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 is the same as leverage for a 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 company assets.
Companies must pay interest on a regular basis and pay it off when it is due. Meanwhile, equity represents the ownership of the company. Therefore, gearing indicates the extent to which a company’s operations depend on debt instead of equity.
To reduce the gearing ratio , companies can pay off debt faster. Alternatively, the company may sell its initial public offering (initial public offering) or rights 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, a 2x ratio shows you that the company’s debt is twice its equity. If the company’s debt is Rp. 80 million, then the company’s equity is Rp. 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 bonds, they must pay off the principal at maturity.
But, if the company has paid off the debt, they still have the assets because the debt does not represent ownership but rather a liability. In addition, lenders also do not have the right to influence the strategic decisions and operations of the company.
share capital . Management may request additional paid-in capital from current owners. Alternatively, they can issue shares in the capital market. The company doesn’t have to pay it back.
Granted, they pay dividends, but it’s not a must. 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 loss of control of the business by the current owners.
How to read gearing ratio
There is no ideal gearing ratio for all industries. Good or bad depends on the nature of operations and cash flow stability. 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. That usually increases as the company expands. If successful, the company generates more profits and cash inflows in the future. That ultimately 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 high financial risk.
But, how high the ratio is that we consider 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 debt, whether the business generates revenue or not. Even when revenue is zero, the company has to pay it anyway.
The high financial leverage makes the company vulnerable to a downturn in the business cycle. When the economy worsens, demand falls as consumers save more. They allocate less money to buy goods and services.
The fall in demand worsened the company’s earnings. And, they have no control over the situation and can only adapt.
The decline in sales reduces the money that goes into the company. On the other hand, they have to pay for operating expenses such as raw materials, salary expenses, selling expenses, general and administrative expenses. As a result, they have difficulty paying interest or paying off debt.
Second , shareholders view it with skepticism. Companies must pay their debts first before distributing dividends. Interest and principal payments make up a large part of the company’s profits. That reduces the distribution of profits as dividends.
Third , lenders and bond investors see high leverage as increasing financial risk. Companies with too high a debt are more likely to default and go bankrupt. Thus, they are reluctant to provide further loans to the company. Or, when willing, they will ask for higher interest to compensate for the higher risk.
The risk is higher when most debts have variable interest rates and interest rates tend to rise. Companies have to spend more money to pay interest and pay off debt.
But, indeed, you cannot judge financial risk only from the high and low gearing ratio in a given year. You should compare with other competitors or industry practices. You also have to check the use of debt, whether for productive activities or not.
Tolerance to 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 the power company for example. Although they tend to have high gearing , they can still secure cash inflows. They usually operate under a monopoly market and thus have strong market power. Their income streams are also resistant to business cycle fluctuations, making them relatively stable. Whether there is a crisis or not, consumers will still pay their electricity bills.
Furthermore, if firms can allocate debt to productive investments, 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 manufacture and sell more products. The additional income they can use to pay interest and pay off debt.
Conversely, if companies do not take on debt, they may miss the opportunity to grow the business by taking on profitable projects. Finally, the company is in an uncompetitive position in the market because the size of the business does not grow, leaving competitive capacity low.
Is low gearing good
The company has low gearing when most of its capital comes from equity. They are considered financially stable. They have low financial risk. During periods of low profits and high interest rates, companies are less susceptible to the risk of default and bankruptcy.
It may indicate conservative financial management. Firms 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.