Concept and calculation of gearing ratio

By | June 16, 2013

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1.        Discussion of gearing

 

1.1    Concept and calculation

Companies fund their activities with capital invested by the owners plus any retained earnings, which is known as equity in incorporated entities. They may also have to borrow funds from banks and other financial institutions and these will form the long term liabilities, frequently referred as to debt (Hussey 2011, p.339). Gearing, also called leverage in the US and some other countries, measures the extent to which a company is funded by debt. One common definition is:

debt ÷ shareholders funds

In addition, there are other definitions, and the other that is widely used (which many people find easier to understand intuitively) is:

debt ÷ capital employed

which is the same as:

debt ÷ (debt + shareholders’ funds)

Regardless of the definition, and there are variations even on debt/equity, it is usual to show gearing as a percentage rather than a fraction (Moneyterms.co.uk 2005).

1.2    The importance of the gearing ratio

The importance of the gearing ratio as a measure of the riskiness of the entity means that the classification of financial instruments as debt or equity is of great importance. Where an entity’s gearing ratio is already high, it will probably wish to avoid issuing new financial instruments that fall into the debt category. A straightforward way of doing this is to issue uncontroversial equity in the form of ordinary shares. However there has been a tendency in recent years to issue complex financial instrument that technically meet the classification of equity but are actually in most essential respects, debts (Ogilvie 2007, p.146). With the increased complexity of the financial product in the market, it is more difficult but still important to calculate an accurate gearing ratio to understand the riskiness of the company. The capital gearing reveals the company’s capitalization which includes three scenarios (Kuppapally 2008, p.215):

Equity capital = Loan capital = Even Gear
Equity capital > Loan capital = Low gear = Over capitalisation
Equity capital < Loan capital = High gear = Under capitalisation

The capital gearing ratio is an important balance sheet ratio, it aides in regulating a balanced capital structure of a company and help to ascertain whether a company is practising trading on equity and to what extent it is practising the trading on equity.

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