What it is: Gearing shows you how much a company depends on debt in its capital structure. It’s a term in the UK and the same as leverage for the term in the United States.
The company’s capital structure is divided into two sources: debt and equity. Debt represents a liability. Meanwhile, equity represents ownership of the company’s assets.
The company must pay interest regularly and repay it when due. Meanwhile, equity represents ownership of the company. Therefore, gearing shows the extent to which a company’s operations depend on debt instead of equity.
To reduce the gearing ratio , companies can pay off debts more quickly. Or, the company can sell its initial public offering or right issue when the company has previously done so. Or, a combination of the two.
How to measure gearing
There are various ways to measure gearing. You can use the debt-to-equity ratio . For example, the 2x ratio shows you that the company’s debt is twice the equity. If the company’s debt is IDR 80 million, then the company’s equity is IDR 40 million.
Here is the formula for calculating gearing:
Debt capital. The sources can come from bank loans, corporate bonds, and medium terms notes . They can be expensive because the company has to pay regular interest (or coupons) regardless of operating conditions and profits. For debt securities, they must pay the principal on maturity.
However, if the company has paid off the debt, they still have assets because debt does not represent ownership but a liability. In addition, lenders also do not have voting rights to influence strategic decisions and company operations.
Share capital . Management may request additional paid-in capital from the current owners. Or, they can issue shares on the stock market. The company doesn’t have to pay it back.
Sure, they pay dividends, but that’s not a requirement. They can choose not to pay dividends. If they don’t pay dividends, they can use the profits to grow the business.
However, the sale of shares to the public resulted in the current owner losing control of the business.
How to read the gearing ratio
There is no ideal gearing ratio for all industries. Good or bad depends on the nature of operations and the stability of cash flow. A stable cash flow allows the company to pay off its obligations in a timely manner, reducing the risk of default.
The ratio also changes over time. It usually increases as the company expands. If successful, the company generates more profit and cash inflows in the future. That in turn increases retained earnings and shareholder equity, lowering the gearing ratio.
Is high gearing bad
A company has high gearing when the majority of its funding comes from interest-bearing debt. We consider the company to have a high financial risk.
But, how high the ratio is that we think it is bad, it varies. It depends on the industry in which the company operates and the business nature of the company.
High leverage is bad because:
First , the company must continue to pay off debts, whether the business generates revenue or not. Even when revenue equals zero, the company has to pay it anyway.
High financial leverage makes companies vulnerable to business cycle downturns. When the economy worsens, demand falls as consumers save more. They allocate less money to purchase goods and services.
Falling demand worsens corporate earnings. And, they have no control over the situation and can only adapt.
A decrease in sales reduces the money that goes to the company. On the other hand, they have to pay for operating expenses such as raw materials, salary expenses, sales expenses, general and administrative expenses. As a result, they find it difficult to pay interest or pay off debts.
Second , shareholders view it with skepticism. The company must pay its debt first before distributing dividends. Payments of interest and principal take up a large part of the company’s profits. It reduces the distribution of earnings as dividends.
Third , lenders and bond investors see high leverage as increasing financial risk. Companies with excessively high debt are likely to default and go bankrupt. Thus, they are reluctant to provide further loans to the company. Or, when they do, they will charge higher interest to compensate for the higher risk.
The risk is higher when most debt has variable interest rates and interest rates tend to rise. Companies have to spend more money to pay interest and pay off debts.
But, indeed, you cannot judge financial risk only from the high and low gearing ratios of a certain year. You must compare with other competitors or industry practices. You also have to check the use of debt, whether for productive activities or not.
Tolerance for debt levels varies between industries. Some industries have high and tolerable gearing ratios . They have relatively stable cash inflows so that their ability to pay debts is also good.
Take for example the power company. Even though they tend to have high gearing , they can still secure cash inflows. They usually operate under a monopoly market so they have strong market power. Their income streams are also resistant to business cycle fluctuations, so they are relatively stable. Whether there is a crisis or not, consumers will still pay their electricity bills.
Furthermore, if companies can allocate debt for productive investment, they can create more income in the future. They can use it to purchase capital goods, build production facilities, acquire other companies, and add new products and services. By doing so, they can produce and sell more products. They can use the additional income to pay interest and pay off debts.
Conversely, if the company doesn’t take on debt, they may miss an opportunity to grow the business by taking on lucrative projects. Finally, the firm is at an uncompetitive position in the market because the size of the business is not growing, making competitive capacity low.
Is low gearing good
Companies have low gearing when most of their capital comes from equity. They are considered financially stable. They have low financial risk. During periods of low profit and high interest rates, companies are less vulnerable to the risk of default and bankruptcy.
That may indicate conservative financial management. Companies may not be able to maximize growth opportunities by taking on debt. On the other hand, shareholders may expect the company to pay dividends on a regular basis.