Meaning | Examples | Formula | Calculation | Interpretation | Good/Bad | Low/High
|Gearing & Leverage: Risk/Growth|
|Capital Structure||HIGH Gearing||LOW Gearing|
Financial gearing, or leverage, is the use of debt–as opposed to equity–for the purpose of business financing, with the aim that the return generated will exceed the borrowing costs.
However, leverage can have the opposite effect and amplify losses if the rate of return does not offset the financing costs of servicing the debt.
As a result, having gearing in a company’s capital structure adds risk but it can also magnify gains if the borrowed funds are well utilized.
Capital structure refers to the way an entity is financed in terms of the proportion of debt (capital contributed by creditors; e.g., funds borrowed from lenders) to equity (capital contributed by owners; e.g., funds from shareholders):
While excessive debt can lead to financial difficulties and companies with low gearing ratios are generally considered more financially sound, the use of debt financing does not automatically raise a red flag.
In fact, debt is typically cheaper than equity and it also reduces the amount of money that shareholders need to invest into a business. When invested properly (i.e., return on investment is higher than the cost of debt), leverage can help boost profits.
Hence, a company that never uses leverage is likely missing out on an opportunity to grow its business by taking advantage of debt financing. This is especially true when interest rates are low and the business enjoys healthy and predictable cash flows.
Keep reading to find out how to calculate, interpret and use leverage and gearing ratios to your advantage >>>
Financial institutions and other creditors primarily use gearing and leverage ratios to determine a borrower’s ability to repay a loan in order to:
Investors assess gearing and leverage ratios to determine if a business is a viable investment when deciding:
For the company itself (e.g. financial managers within the business), gearing and leverage ratios are a useful way to:
|Gearing & Leverage Calculation: Common Formula Variations|
|Debt||Equity Gearing||Total or Capital Gearing|
|Long-term Debt||Long-term Debt ÷ Equity||Long-term Debt ÷ (Debt + Equity)|
|Total Debt||(Long-term Debt + Short-term Debt) ÷ Equity||(Long-term Debt + Short-term Debt) ÷ (Debt + Equity)|
Gearing and leverage can be calculated in a number of ways, including the two most commonly used methods below:
In practice, the Total or Capital Gearing formula is usually used more often than Equity Gearing.
What exactly do you need to include in the gearing/leverage calculation? >>>
The gearing/leverage formula typically includes either total borrowings or long-term borrowings only:
This variation is useful when most of a company’s debt is long-term, but not when a company has a large amount of short-term debt (e.g., when creditors are not willing to extend long-term lending to the company).
This is the most comprehensive form of the gearing/leverage ratio, which comprises all types of non-current as well as current debt
Note that not all liabilities are regarded as debt for the purpose of the gearing/leverage calculation, for example:
|Debt in Gearing/Leverage Ratio Calculations|
|Include in Gearing Calculation||Exclude from Gearing Calculation|
|Line of credit (e.g., bank overdraft, loan, mortgage)||Deferred revenue|
|Leases (e.g., capital lease)||Accounts payable|
|Notes payable (including the current portion maturing in <1 year)||Accrued expenses|
|Bonds payable (<1 year and >1 year)||Dividends payable|
Preference share capital is typically treated as debt rather than equity because it has the priority right to the receipt of interest, dividends or any other claim on distributable earnings before ordinary shareholders.
Nevertheless, sometimes, non-redeemable preference shares (less common than redeemable) are still classified as equity.
The ratio is usually converted into a percentage by multiplying the fraction by 100, because it makes it easier to express how much of a company’s equity would be required to pay off its debt.
Below are a few of the ratios most commonly used to measure the debt load of a company that fall under the umbrella category of financial leverage and gearing:
|Debt, Gearing & Leverage: Ratio Alternatives (Examples)|
|Ratio:||Also known as:||Formula:|
|Debt ratio||debt-to-assets||Debt ÷ Assets|
|Debt-to-earnings||debt-to-EBITDA (earnings before interest, taxes depreciation and amortization)||Debt ÷ Earnings|
|Equity ratio||equity-to-assets||Equity ÷ Assets|
|Equity multiplier||assets-to-equity||Assets ÷ Equity|
|Interest cover ratio||interest coverage||Operating Profit ÷ Debt Interest|
|Interest gearing ratio||n/a (inverse interest cover)||Debt Interest ÷ Operating Profit|
|Debt service coverage ratio||DSCR (debt service = principal + interest)||Operating Profit ÷ Total Debt Service|
|Gearing & Leverage|
|Equity gearing & leverage ratio||debt-to-equity, D/E||Debt ÷ Equity|
|Capital or Total gearing & leverage ratio||debt-to-capital||Debt ÷ (Debt + Equity)|
This article focuses primarily on the last two ratios, i.e., equity gearing (debt-to-equity) and capital gearing (debt-to-capital).
Since there are so many variations of the gearing/leverage ratios, always make sure that you are comparing apples-to-apples by clarifying that the ratios have been calculated on a consistent basis.
Calculate the gearing/leverage ratio for Company A based on the extract from its financial statements below:
|Question: Gearing & Leverage Ratio - Calculation Example|
|Balance Sheet||Company A|
|Long-term debt due within 1 year||$30,000|
|Total Short-term Debt||$60,000|
|Long-term capital lease||$20,000|
|Other long-term debt obligations||$60,000|
|Total Long-term Debt||$120,000|
Let’s calculate the gearing/leverage ratio with the four most commonly used formulas:
|Answer Solution: Gearing & Leverage Ratio - Calculation Example|
|EQUITY Gearing & Leverage||Long-term Debt = Long-term Debt ÷ Equity|
|$120,000 ÷ $180,000 = 0.67 or 67%||For every $1 in equity, Company A has 67 cents in leverage.|
|Total Debt = (Long-term Debt + Short-term Debt) ÷ Equity|
|($120,000 + $60,000) ÷ $180,000 = 1.00 or 100% or 1 times||A ratio of 1 implies that creditors and investors are on equal footing in Company A’s capital structure as for every $1 of Company A owned by its shareholders, Company A owes $1 to creditors.|
|Answer Solution: Gearing & Leverage Ratio - Calculation Example|
|TOTAL (or CAPITAL) Gearing & Leverage||Long-term Debt = Long-term Debt ÷ (Debt + Equity)|
|$120,000 ÷ ($180,000 + $180,000) = 0.33 or 33%||One third of Company A’s capital is comprised of debt, while 2/3 belong to the company’s shareholders.|
|Total Debt = (Long-term Debt + Short-term Debt) ÷ (Debt + Equity)|
|($120,000 + $60,000) ÷ ($180,000 + $180,000) = 0.50 or 50%||50% gearing ratio means that for every $1 in shareholder equity, Company A has 50 cents (i.e., exactly half) of debt financing.|
Are you wondering if the ratios we’ve just calculated are high/low and good/bad?
You’re 100% correct – a ratio is virtually meaningless until it is evaluated in context.
Keep reading as the next part of this article explains how to do just that – analyze and interpret gearing & leverage ratios >>
Although there is no absolute guide to what an ideal gearing ratio should be, a general rule of thumb suggests minimum 25% and maximum 50% leverage ratio as a safe benchmark.
In practice, many companies operate successfully with a higher leverage and gearing ratio than this, but 50% is nonetheless a helpful benchmark.
|Ideal Gearing & Leverage Ratio: High or Low?|
|>100%||Very High||A gearing/leverage ratio above 1.0 indicates that a company has more debt than equity.|
|=100%||Very High||A gearing/leverage ratio of 1.0 indicates that a company has as much debt as it has equity.|
|>50%||High||A gearing/leverage ratio that exceeds 0.50 typically represents a highly geared/leveraged company that is at a greater risk of insolvency, loan default and financial failure.|
|25%-50%||Normal||A gearing/leverage ratio between 0.25 and 0.50 is generally considered optimal.|
|=50%||Normal||A ratio of 0.50 indicates that a company has twice as much equity as it has debt.|
|<25%||Low||A gearing/leverage ratio lower than 0.25 is usually considered low-risk.|
|<10%||Very Low||A gearing/leverage ratio below 0.10 indicates that a company has almost no debt relative to equity.|
Therefore, if the ratio is over 50% and worsening, a company’s debt position would be worth examining, because leverage and gearing indicate the risk attached to the entity’s finance.
It is important to remember that although companies with higher gearing ratios generally carry more risk, high financial leverage does not necessarily indicate financial distress.
In other words, excessive and uncontrolled debt levels can be risky for a company and its investors. On the other hand, if a company’s is able to generate a higher rate of return than the interest paid on its loans, then the debt can help to accelerate profitability and business growth.
In many cases, having debt on the balance sheet is a smart strategic business decision, including the following 5 instances:
High leverage and gearing ratio can be beneficial when a company is using the borrowed funds to increase its return on equity (ROE) and is able to comfortably service the debt obligations with the ongoing cash flows from the rising revenue income.
As such, the use of debt financing can accelerate business growth and support long-term profitability (e.g., expansion into new markets, mergers & acquisitions, improvement of business offering, development of new products/services).
The cost of debt is typically lower than the cost of equity. Therefore, the higher the proportion of debt to equity, the lower a company’s weighted average cost of capital (WACC). Naturally, this only works up to a certain point.
When a company that is otherwise financially sound experiences a temporary cash flow shortfall (e.g., due to seasonal cyclicality), it can take advantage of the many debt financing options readily available from financial institutions and other lenders for that exact purpose.
For example, agricultural companies often need to borrow money on short-term basis as the industry is affected by seasonal demand.
As long as the borrower meets their requirements, lenders may promptly provide funding for significant time-sensitive investments that would be challenging to finance from shareholders’ equity due to the time constraints (e.g., acquiring assets of a competitor that is exiting the market).
Debt financing allows a company to raise new capital to support its operations without affecting the ownership composition of the business.
Many shareholders prefer sourcing capital from debt rather than equity as issuing more shares of stock can dilute their ownership stake in the company.
As a company optimizes the use of gearing/leverage for maximum profitability and minimal use of equity to run its operations, shareholders benefit from the increase in both ROE (return on equity) as well as EPS (earnings per share).
All things being equal, a company with a higher level of gearing/leverage faces increased financial risk in terms of variability of returns to shareholders, long-term liquidity and ultimately the ability to remain in business.
When a company’s debt load is too high relative to its assets, the burden of debt principal and interest repayments takes up such a significant portion of cash flows that even a relatively small financial performance issue could result in the business not being able to generate enough cash to pay back its debt obligations.
This is also why high gearing/leverage ratios may prevent a company from attracting additional capital as creditors and shareholders are less protected in the event of a financial decline or liquidation–and so less likely to recuperate their money.
High levels of gearing and leverage indicate that a company relies heavily on debt to finance its long term needs, which increases the level of risk for the company’s common ordinary shareholders.
Why? Because the interest and capital repayments on debt must be made regardless of the company’s profits, whereas there is no obligation to make payments to equity.
Hence, a highly geared company must earn enough profit to first cover its payments to holders of debt before anything is available for distribution to the holders of equity (e.g., dividends).
On the other hand, if the borrowed funds are invested in initiatives that provide returns in excess of the cost of debt capital, then shareholders will enjoy increased returns on their equity.
Therefore, this leads to greater volatility in dividends paid to shareholders where a company is highly geared.
Ultimately, gearing and leverage ratios measure a company’s ability to remain in business because high proportion of debt to equity can cause:
Lower leverage and gearing ratios tend to be more desirable for companies as well as their investors because they generally indicate lower financial risk associated with better debt management and financial stability, as reflected in:
Nevertheless, not all debt is bad debt and a low leverage/gearing ratio does not necessarily mean that a company’s capital structure is healthy. Quite the opposite, in fact. >>>
A low gearing ratio is typically indicative of:
Therefore, the main issue with low leverage ratios is that the companies that rarely borrow do not take full advantage of cheaper forms of financing as a means of responsibly growing their business and boosting earnings, ultimately missing out on opportunities that their competitors may take.
No one single metric provides a comprehensive view of a company’s financial health. Likewise, the gearing ratio is just a small piece of the big puzzle.
Hence, the optimal level of leverage for a company should be determined by considering many factors, including:
Healthy levels of gearing and leverage vary wildly between industries.
For example, high ratios can often be found in industries that are:
Conversely, a high ratio could be risky in an industry with:
Hence, gearing ratios are usually used as a tool to compare financial leverage of similar companies within one industry sector.
For instance, a company with a gearing ratio of 60% could be regarded as high risk when evaluated in isolation. However, when compared to its key competitor that reports leverage of 70% and the industry average of 75%, the company’s debt levels appear more satisfactory.
Even within the same industry, a safe gearing ratio can vary from company to company, depending on the ability of a business to manage its debt, as signalled by indicators including:
For example, a start-up with unpredictable cash flows is able to handle much lower level of gearing than a well-established mature corporation that continuously generates strong reliable cash flows and could easily pay off its debt by issuing equity if needed.
Similarly, the use of leverage is beneficial when a company enjoys strong and stable cash flows as the income becomes amplified. However, when experiencing a decline in profitability, a highly geared company is at a higher risk of default than a less geared one in the same situation.
There are several situations when companies deliberately take on financial gearing to strengthen their capital structure, some of which include:
Companies have a number of debt and equity management methods at their disposal to improve the capital structure of a business and its leverage/gearing ratio, such as:
Companies can take several steps to reduce their leverage/gearing ratio, such as :
Raising equity capital by issuing more shares can also decrease a company’s gearing ratio.
Furthermore, companies can negotiate with their lenders to convert any existing debt into equity shares.
Expense reduction will lower the gearing ratio by decreasing liabilities through:
Moreover, a company can free up additional cash to pay down debt by reducing the amount of money tied up in its working capital:
Another method to decrease a company’s leverage/gearing ratio is to increase its revenue, profits and retained earnings, which can help to:
Conversely, a company can increase its leverage/gearing ratio in many ways, including:
The term “leverage” can either be used interchangeably with the word “gearing” or differentiated as follows:
|Gearing vs. Leverage: What’s the Difference?|
|Knowledge Domain||Leverage: Alternative Uses|
|Finance - Gearing: Identical Meaning||Leverage is an alternative and synonymous term for gearing, where the two words have the same meaning and are used interchangeably.|
|“Leverage” tends to be used more frequently in the United States, while “gearing” is more common in the United Kingdom and Australia.|
|Finance - Gearing: Converse Meaning||Leverage also describes the converse of gearing and is used to measure the proportion of capital or assets financed by equity (leverage), as opposed to debt (gearing).|
|Example - Total (or Capital) Gearing and Leverage ratios:|
|• Gearing = Debt Capital ÷ Total Capital|
|• Leverage = Equity Capital ÷ Total Capital|
|• Leverage = Total Capital ÷ Debt Capital|
|Finance - Asset Financing||Debt finance used by companies and individuals (e.g., mortgage loan) to increase their return on investment by utilizing the borrowed funds so that the return generated is greater than the cost of servicing the debt (e.g. debt-to-assets ratio).|
|Banking||Financial institutions lend a proportion of deposits to customers that need a loan to make a profit.|
|Economics||Comparison of consumer debt to disposable income used for economic analysis purposes.|
|Physics||Lever effect where a simple machine amplifies a relatively small input force into a greater output force.|
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