Gearing refers to the relationship between the company’s debt to equity. It is expressed in a ratio. It shows the extent to which lenders versus shareholders fund the firm’s operations.
It measures financial leverage in a nutshell. When the debt-to-equity ratio is great, the business may be highly geared or highly leveraged.
This is the ratio of debt to equity. Gearing is a measure of balance sheet risk – the higher the proportion of debt in the funding mix, the higher profits will be in good times, and the lower they will be in bad times.
Gearing is related to risk. Gearing increases the volatility of profits. That is why lenders get their interest paid before any amount is paid to equity shareholders.
Financial gearing depicts the company’s proportion of debt and equity to support its operations. The financial gearing ratio shows the debt in the equity or shareholder’s funds.
Gearing can also be computed as the ratio of debt plus equity or the ratio of equity to total assets or debt to EBITDA. EBITDA stands for earnings before interest tax and depreciation.
The formula used for financial gearing = (Short-term debt + Long-term debt + Capital leases) ÷ Equity
For example, Sinra Plc cannot sell any additional shares to investors at a market price or at a fair discount to the market price to fund its expansion. Therefore, Sinra Plc obtains a $ 10 million short-term loan instead.
The company currently has $4 million of equity. The ratio would then be 2.5x debt to equity. Sinra Inc is here highly geared or leveraged.
The company operates in financial gearing due to the following reasons:
- The present owners don’t want to dilute their stake by issuing shares to proposed or new investors. Hence, debt is the only option for them to raise funds without diluting their stake. Hence, the owners or shareholders leverage the company or move towards financial gearing.
- The company needs to raise immediate cash for various strategic acquisitions or internal crises and may not raise from existing investors to meet its requirements.
- The company may want to increase its return on equity measurement. It can only do so by using the funds from debt to buy back shares from investors.
- When the company has an underflow of cash from receivables, the operations may get hampered due to cash distress. Hence, the company may raise additional cash to bolster its operations.
The important thing to point out in financial gearing is its major disadvantage. The cost of debt may increase due to changes in market rates.
The company may achieve an insufficient return on its use of funds and hence, cannot pay for interest or return of principal.
Whichever is the case, high leverage presents a significant risk of going concerned to the company.
This becomes a major distraction in the economy’s downturn when cash becomes tough to raise.
A recent example is the coronavirus, where it will be difficult to raise cash for certain sectors like theatres and aviation.
Financial gearing must be reasonable to allow some use of additional funds while not getting the entire business on hold or jeopardizing the existing operation.