Financial Gearing can be defined as the relative proportions of debt and equity that the company requires in order to fund, or support its operations.
Gearing in itself can be used as a measure of balance sheet risk. It shows the overall reliance that the company has on external sources of funds.
In the cases where the company has a higher proportion of debt in the overall funding mix, it implies that the company will have higher profits in years where they perform well.
Therefore, gearing can be used to predict the overall payout structure of the company in years where they can perform up to the mark, as compared to times when they lag.
The formula used for financial gearing is (Short-term debt + Long-term debt + Capital leases) ÷ Equity. In other words, it comprises a summation of short-term debt, long-term debt, and capital leases. This summation is then divided by the existing equity in the company.
Interpretation and Analysis
Higher financial gearing is mostly associated with a higher threshold of risks. This is mainly because of the reason that it is directly associated with increased volatility.
If the company is not able to generate profits, the lenders or the debtholders have the first call on profits. In this regard, the gearing ratio is mainly a reflection of the borrowed money compared to equity.
Hence, in this regard, it can be seen that financial gearing mainly gauges the underlying risk of failure of the business. In high gearing (a higher chunk of finances being raised from debt), the company is regarded as a high-risk venture, predominantly because most of the resources are built on loans, which have to be repaid.
Reasons for Financial Gearing
However, both equity and debt need to be used in a mixture to create an optimal capital structure. An exception to aiming for the optimal capital structure is a few other reasons why business owners opt for having a high financial gearing.
Firstly, it is often because the owners do not want to dilute their ownership structure by issuing shares to new investors. In this case, they might prefer to raise finance via debts.
Alternatively, companies might also opt for higher financial gearing because of the urgency they need finances.
In the case of equity financing, which is a relatively time-consuming process, because of which it’s a preferable solution to raise money through debt financing.
However, the greatest advantage of financial gearing is that it is relatively cheaper to raise debt than equity.
If the company is not legally registered on the stock exchange, it is expensive to go for an IPO (Initial Public Offering) and get listed before being allowed to sell shares publicly.
Drawbacks of High Financial Gearing
Speaking of the drawbacks of high financial gearing, it can be seen that it often results in an increased cost of debt because of volatility in the market rates.
Similarly, it also deters the company from accurately predicting its cost of debt because it is subject to changes that take place otherwise. In the same manner, in the case of highly leveraged firms (with a gearing ratio of greater than 50%), it shows that the company has a significant amount of debt to service.
It can be constituted as a riskier capital structure since the amount has to be paid back. It also reflects that the company is highly susceptible to economic downturns and changes in interest rates.
In the same manner, debt financing also involves collaterals as security when the company fails to pay back the loan amount.
Therefore, it is even riskier because it means that the company’s net asset position stays stagnant. Inequity, there is no need for collaterals, and the amount does not have to be paid back because the overall risk threshold is lesser.
In this regard, it can be seen that financial gearing can be defined as a metric used to compare the debt and equity position of the business.
Businesses with higher debts are referred to as highly geared businesses, and businesses are referred to as low geared businesses.