What is Financial Gearing? Definition, Formula, Analysis, Drawbacks

Definition

Financial Gearing can be defined as the relative proportions of debt and equity that the company requires 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 it 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 when they can perform up to the mark, as compared to times when they lag.

Formula

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 cannot generate profits, the lenders or the debtholders have the first call on profits. In this regard, the gearing ratio is mainly a reflection of 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 that must be repaid.

List of Top 7 Financial Gearing Ratios

Financial gearing ratios measure the extent to which a company operates with debt financing.

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They can be useful for investors and creditors and any entity that wants to understand how a company is leveraging its assets. Here is a list of the top 7 financial gearing ratios:

  1. Debt-to-Equity Ratio – This ratio compares a company’s total liabilities to its shareholder equity, providing insight into how much debt the company has relative to its equity funding.
  2. Interest Coverage Ratio – This ratio measures how many times a company’s earnings cover the interest payments before interest and taxes (EBIT). A higher number indicates better coverage.
  3. Debt Service Coverage Ratio – This ratio measures how often the total debt service requirements (including both principal and interest payments) are covered by a company’s EBIT. A higher number indicates more coverage.
  4. Asset Turnover Ratio – This ratio measures how efficiently a business utilizes its assets in terms of sales or revenues generated from those assets.
  5. Fixed Charge Coverage Ratio – This ratio measures the ability of a business to cover fixed charges such as lease payments, interest payments on debts, and preference dividends out of its earnings before fixed charges and taxes (EBFC).
  6. Cash Flow To Total Debt Ratio – This ratio compares cash flows from operations to total debt, indicating whether the business generates enough cash flows from operations to meet its obligations for all types of debts.
  7. Quick Ratio – This ratio compares the sum of cash plus short-term investments to current liabilities, providing an indication of whether or not there are enough quick resources available to pay off immediate debts without having to liquidate investments or sell long term assets.

These financial gearing ratios provide valuable insight into a company’s leverage position and can help guide strategic decisions regarding risk management and investment opportunities.

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Advantages of Financial Gearing

Financial gearing can provide a number of advantages for companies that leverage their assets. Here are some of the most common benefits:

Cash Flow Optimization

One of the primary benefits of financial gearing is that it allows a business to optimize its cash flows by leveraging debt to invest in assets that generate higher returns than the cost of servicing the debt.

For example, taking on additional debt to finance investments in new equipment can help increase revenues and profits over time.

Financing Growth

Companies can also finance growth by taking on additional debt without having to issue more equity or dip into existing cash reserves.

Taking on additional debt can be an effective way for businesses to expand operations without altering existing ownership structures or diverting resources from other projects.

Tax Benefits

In some cases, taking on additional debt may also provide additional tax benefits since interest payments may be deductible as an expense against taxable income.

This can help businesses maximize their profits and reduce their overall tax burden.

Increased Leverage

Financial gearing can also make it easier for businesses to access capital markets and tap into investment opportunities that may otherwise have been out of reach due to limited resources or capital constraints.

This increased leverage can help companies take advantage of potential growth opportunities while minimizing risk exposure.

Financial gearing provides numerous advantages that can help businesses increase profit margins while minimizing risks associated with investing in new assets or expanding operations.

Disadvantages of Financial Gearing

While financial gearing can provide several benefits, it also has some potential risks and disadvantages. Here are some of the most common drawbacks to consider:

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High Fixed-Costs

The use of debt financing involves fixed-interest payments regardless of how the company is performing. This can increase costs for businesses struggling in terms of sales or profits since they may still have to make regular payments on their outstanding debts.

Risk of Default

Businesses that leverage too much debt may risk defaulting on their loans if they fail to generate enough income to cover all principal and interest payments.

Defaulting on a loan can have major consequences for both companies and owners, including loss of assets and potential legal action from creditors.

Increased Regulation

In some cases, leveraging financial gearing may also subject companies to increased regulatory scrutiny due to higher debt-to-equity ratios or higher overall levels of leverage. This can lead to additional costs for corporations related to filing additional documents or reports with regulators.

Reduced Flexibility

Finally, businesses with high levels of debt may have limited flexibility when it comes to making major decisions, such as investing in new projects or expanding operations due to existing commitments related to servicing outstanding loans.

Overall, while financial gearing can help businesses improve cash flows, access capital markets, and finance growth, it also carries risks such as high fixed costs, risk of default, increased regulation, and reduced flexibility that should be considered before deciding whether or not it is right for a particular business situation.

Conclusion

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.