Gearing ratio help to determine financial risk in the financing structure of the business. It helps study the relative volume of the debt and equity to assess risk in the overall financing structure. If the debt proportion of the company is higher, it’s considered to be risky in terms of investment. On the other hand, if debt proportion is lower, it’s regarded as a stable business.
Explanation for gearing ratio
The business needs to finance its operations via equity and debt. A higher debt proportion of the business is not considered good as there is an increased risk of financial leverage associated with it and the associated cost of interest.
Although, sometimes higher gearing can be a better option in terms of expansion and business growth. However, the business must have projects with a higher rate of return than the cost of capital. Further, the tax advantage is another excellent attraction for financing via debt, as interest is an allowable tax expense. The dividend payment of equity financing does not qualify for the tax relief.
Different metrics have been developed to assess the gearing status of the business. These metrics include debt to equity ratio, time interest earned ratio, equity ratio, and debt ratio.
Equity debt is the prime ratio of gearing assessment. It compares debt in the financing structure with the equity and helps understand the financing structure with the proportion. If the proportion of debt is higher and the ratio calculated is more than one, the business is considered risky with enhanced risk of financial leverage. It’s calculated with the following formula.
Debt to equity = Debt/Equity
Time interest earned helps to connect the profit-generating ability of the business with the cost of capital. If an answer of this ratio is more than one, it means the profit-generating ability of the business is significant and vice versa. Higher interest earned is a desirable status for stable business operations. This ratio is calculated with the following formula.
Time interest earned = Earnings before interest and tax/total cost of interest.
Similarly, the equity ratio compares shareholder’s equity with the assets owned. It helps to understand if proceeds raised with the equity have been used to finance the purchase of assets. A lower equity ratio or less than one is desirable because it indicates that assets have been financed with equity. There is space for taking charge of the assets under ownership of the company’s shareholders. The following formula calculates the equity ratio.
Equity ratio = equity/assets
Likewise, the debt ratio helps compare the debt of the business with the total assets owned. From an investor’s perspective, a lower debt ratio is desirable because they feel an element of safety if total assets are more significant than the total debt. The formula to calculate the debt ratio is as follow,
Debt ratio = total debt/total assets
Conclusion
Gearing assessment is one of the essential aspects of financial analysis, and it helps to understand the financing structure and other related details of the business. If the debt proportion of the business is more significant, it may be a risky investment—however, other factors like business profitability and earning potential need to be considered. In addition to this, gearing ratios can be better understood with multiple metrics like debt to equity, EBIT to interest expense, and debt ratio, etc.
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