Gearing Ratio — a ratio that compares the level of internal and borrowed funds. This ratio shows how a company uses the money of creditors and its own money. Also, it can be calculated using the market value of both sources of funding in the case of a public company or using a combination of the book value of debt and the market value of equity.
What is Gearing Ratio
The gearing ratio is one of the calculated characteristics that serve to assess the financial position of the company. The calculation of this ratio is necessary when they want to quickly get indicative data on the financial situation in the organization. It shows the proportion of borrowed and internal funds of a legal entity and serves as an indicator of financial health.
The predominance of own funds indicates a good financial position and the dominance of borrowed funds indicates probable financial instability. The optimal gearing ratio varies by industry. It is important to know the value of this coefficient for persons who invest their funds in the organization: investors, banks, lenders, and suppliers providing deferrals.
An acceptable level of internal funds ensures a normal level of borrowing funds without increasing risk. From a tax point of view, a level comparable to the capital structure of similar companies in the private sector for the relevant period is considered acceptable. For tax purposes, the main criterion is the equity ratio (the ratio of equity to non-current/long-term assets), which is acceptable at a level of 30%. 70% of non-current assets should be financed by borrowed funds.
The acquisition of borrowed funds (credits) leads to an increase in the level of borrowed capital and, therefore, increases the risks of non-payment of the company. The higher the debt level, the higher the company's dependence on external creditors. A high degree of leverage increases the risks of the lender since the part of the assets underlying the company's funds and payable in the event of default will be insufficient to fully repay its borrowing obligations in case of bankruptcy.
A high gearing ratio is typically accompanied by a high interest coverage ratio and a high debt service coverage ratio, as they encourage interest and principal payments that should be financed by sales. On the other hand, in terms of "financial leverage", a relatively low level of internal capital leads to a high return on this money. Therefore, it is also necessary to take into account the profitability of total funds (internal and borrowed capital). A high level of borrowed funds increases the risks of loss of income due to a high level of debt service, since most of the profit is directed to interest expenses and, as a result, with an increase in liabilities, the break-even point (“financial leverage”) also increases.
Application of Gearing Ratio
The gearing ratio is used to conduct a financial analysis of the company's solvency and bankruptcy risks. Many institutions and individuals need to calculate it.
Who calculates the gearing ratio:
- banks that decide on the issuance of all types of loans and bank guarantees;
- factoring companies;
- financial analysts that compare similar indicators within industries.
Analysis of the usage of internal and borrowed capital of organizations is a method of accumulation, transformation, and use of accounting and reporting information. There are different goals of such analysis.
Why it is necessary to analyze the gearing ratio:
- assess the current and prospective financial situation;
- substantiate the possible pace of development of the organization from the standpoint of providing them with sources of funding;
- identify available sources of funds and evaluate rational ways to mobilize them;
- predict the position of the enterprise in the capital market.
The gearing ratio may be used in various situations when the company is on the verge of some significant changes. In routine work, the financial situation is seen without the calculation of coefficients.
When it is necessary to calculate the gearing ratio:
- Attraction of investors. A business plan will look much more attractive with specific calculations and analysis of current indicators. Sometimes they are required to be presented in dynamics, based on several consecutive periods.
- Modernization of production. A program of measures for modernization and a new financial policy is being developed based on the data obtained.
- Liquidation of the company. Calculation of the gearing ratio will allow the liquidators to assess the possible risk of declaring bankruptcy.
- Participation in a new project as a part of a group. Potential partners have the right to request data on the stability of the company, especially if the project is extended in time for more than a year.
- The conclusion of an agreement on the terms of deferred payment. The organization will increase its chances of obtaining a contract and agree on more favorable conditions if it can prove its ability to pay within the time allotted by the agreement.