Gearing is ratio between Long-term Liabilities and Capital Employed. It compares Long-term Liabilities with Capital Employed.
What does Gearing measure?
Gearing measures how much of the capital employed in a business is financed by long-term debt, or Long-term Liabilities. Specifically, Gearing measures the percentage of capital employed that is financed by long-term borrowings such as mortgages, long-term bank loans and bonds.
Gearing is used to analyze the total capital structure of a business to assess a firm’s long-term liquidity position – whether or not the business is burdened by its loans. It is because Finance Managers have a very difficult choice to make. On one hand, most businesses require long-term debt to finance business growth as equity financing (the business’s own financial resources) is rarely sufficient. On the other hand, the introduction of long-term debt increases financial risks. Although Gearing can make it more difficult to achieve high profits, in the end many businesses decide to use external finance to fund their future expansion.
A firm is said to be ‘highly geared’, or highly leveraged, if it has a Gearing ratio of 50% or above. High Gearing increases the risk of not being able to make timely Interest payments from Net Profit Before Interest and TAX.
Gearing measures how much of the capital employed in a business comes from long-term debt, or Long-term Liabilities.
How to calculate Gearing?
The figures for working out Gearing can be found in Balance Sheet:
| Long-term Liabilities | |||
| Gearing = | ━━━━━━━━━━━━━━━━━━━━ | x 365 | |
| Capital Employed |
Comment
Gearing is expressed as a percentage.
When a business with Long-term Liabilities of USD$5,000,000 has its Capital Employed of USD$20,000,000, its Gearing will be 25%. This means that 25% of the firm’s long-term sources of finance come from external interest-bearing sources, while the other 75% represents internal long-term sources of finance such as Share Capital and Retained Profit.
High Gearing: The higher the gearing, the larger the firm’s dependence on long-term external sources of finance. The greater the reliance of a business on loan capital, the more ‘highly geared’ it is. Gearing of over 50% indicates a ‘highly-geared’ business, therefore risky. This is where the risk come from:
- Higher Interest. More long-term debt financing requires the firm to incurs higher costs of interest payments to banks and/or debenture holders. The higher the Gearing, the more interest the firm must pay, hence lower Net Profit After Interest and TAX. This will affect the ability of the company to pay Dividends and gain Retained Profit.
- Lower liquidity. In addition, when a central bank increases interest rates, a rise in interest rates will mean higher monthly interest repayments on outstanding loans. This will cause a problem of low liquidity during an economic downturn due to lower cash inflows from sales, and declining profits. Interest must be paid even when profits are low. ‘Highly geared’ businesses are more exposed when loan repayments are high, while cash inflows from sales tends to fall in a recession.
- Difficult to borrow more. Lenders are less likely to lend money to firms with high Gearing due to their current large loan commitments. A ‘highly geared’ business will have it more difficult to obtain new loans. Such firms are more prone to experience financial difficulties, hence may be taken over by larger rivals.
Appropriate Gearing: In general, no more than half of the business’s capital should come from long-term borrowings – Gearing should not be higher than 50%. The safe level of Gearing for many typical businesses is around 20%-30%. However, the acceptable Gearing level to a specific business will depend on many factors:
- Business size. There is a link between a firm’s market status and its ability to repay long-term debts. Large multinational companies, even with high Gearing, are very likely to be able to repay their debts.
- Interest rates in the country. If interest rates are close to zero, then businesses are less vulnerable even with high Gearing. Because low interest rates minimize any interest repayments.
- Profitability. Firms with good long-term prospects of making profit, are less bothered by high Gearing. High potential returns from new products can minimize their exposure to using external finance to fund the expenditure on Research and Development (R&D).
Some people argue that optimal Gearing is determined by the individual company comparing with other companies within the same industry.
Low Gearing: A low Gearing ratio is an indication of a safe business strategy. The lower the Gearing, the smaller the business’s dependence on long-term sources of borrowing. It means that more capital employed in the business comes from Equity, the business’s own finance including Share Capital and Retained Profit. The weaker the reliance of a business on loan capital, the less ‘highly geared’ it is. As Interest must be paid on those long-term borrowings, even when profits are low, with less long-term debt, the business will incur lower costs of debt financing minimizing interest repayments to banks or debenture holders. Therefore, the lower the Gearing, the less interest the firm must pay, hence higher Net Profit After Interest and TAX. Shareholders and potential investors are interested in firms with the low Gearing ratio as it helps to minimize the level of risk of a firm not making any profit, hence not having any money to pay out dividends and reinvest earnings for future growth. Since lenders have to be repaid first, low Gearing may increase the amount paid to shareholders and the amount retained within a business for reinvestments. When the profitability of the firm is high, then potential returns can be very attractive. So, low Gearing in highly profitable firms positively affects the return on shareholders’ equity. On another hand, low Gearing might suggest that management is not borrowing enough to invest in the firm to expand it rapidly.
Example for Gearing
COMPANY A
Company A has Sales RCompany A has Long-Term Liabilities of USD$500,000 and Capital Employed of USD$1,000,000 in 2020. The remaining part of Capital Employed of USD$500,000 comes from internal long-term sources of finance such as Share Capital and Retained Profit. In 2021, Long-Term Liabilities were USD$300,000 and Capital Employed was USD$900,000. The remaining part of Capital Employed of USD$600,000 comes from internal long-term sources of finance such as Share Capital and Retained Profit.
| 2020 | 2021 | ||||||
|---|---|---|---|---|---|---|---|
| Long-term Liabilities | $500,000 | $300,000 | |||||
| Equity | $500,000 | $600,000 | |||||
| Capital Employed | $1,000,000 | ➘ | $900,0000 | ||||
| Gearing | 50% | ➘ | 33.3% |
In 2021, Company A has Gearing of 33.3% comparing with 2020 when Gearing was as much as 50%. It means that in 2021, the firm is less dependent on long-term loans to finance its operations. More Capital Employed comes from internal sources of finance. This is a safer business strategy.
How to improve Gearing?
Gearing of a business could be reduced by using more internal long-term sources of finance to increase Capital Employed. How to do that?
1. Increase Equity:
- Increase Share Capital. By issuing more shares to investors instead of buying back shares. By share buy-backs, the company will spend its own cash to lower Share Capital, hence the Equity of a business will decrease.
- Increase Retained Profit. By paying out less dividends to investors.
2. Decrease Long-term Liabilities:
- Pay off some long-term debt. This can be done when the firm has large amounts of Cash in Balance sheet, or by issuing new shares to investors in exchange for cash. Settling a large debt can decrease the Gearing ratio.
- Refinance long-term debt. Negotiate with the bank to replace its current debt with a lower interest rate debt. Obtaining low-cost, fixed-rate debt can be done by extending the loan period. Choosing loans with lower interest rates would decrease Gearing as well.
By increasing the owner’s equity, or shareholders’ funds, as a proportion of Capital Employed, the firm will be able to lower the Gearing ratio.
The real problem facing Finance Managers is how much long-term debt the firm can handle before the benefits of business growth outweigh the costs of high Gearing and financial risks. The business needs to find a balance in financing streams between Debt Finance vs. Equity Finance.
