Understanding the gearing ratio

Understanding the gearing ratio

from businessbankingcoach.com

in association with

Gearing refers to the mix of debt and

equity funding that a business uses

to finance its assets. Gearing is also

known as leverage.

What is gearing?

From a lender’s perspective,

we are interested in the

gearing ratio because it

reflects the degree to which

the business relies on funds

provided by outside sources

of finance (e.g. bank,

suppliers, etc.) in relation to

that provided by the owners.

But, how is “debt” defined in this context?

In fact, the definition of debt for

the purposes of calculating the

gearing ratio varies between

lenders.

Some banks consider debt to be the

same as total liabilities…….

Some lenders consider debt to be the

same as total liabilities…….. that is,

interest-bearing debt plus accounts

payable and other non-interest-bearing

current liabilities.

Other lenders take only interest-bearing debt into consideration.

In deciding which definition to use, the

thing to ask yourself is ……“what do I

want the gearing ratio to tell me about?”

If you want to know how the

business funds it assets and

what degree of risk it takes in

doing so, you would look at

using the total liabilities

figure in the calculation.

But, if you’re a lender

and you want to know

what the business’

capacity for additional

bank debt is, you

would use the

interest-bearing debt

figure.

Obviously, you

might want to

have both these

pieces of

information so

you might use

both ratios

in your

assessment

Gearing = Total liabilities

Total shareholders’ equity

Gearing = Total interest-bearing debt

Total shareholders’ equity

Depending on which ratio is to be used,

the formula will be;

or

Where the outside

sources of funding

(i.e. the liabilities or

debt) exceed the

owners’ equity, the

gearing ratio will be

1 or higher

If the resulting ratio is higher than 1, in

the first of those calculations this will

indicate that more funding is provided by

all outside sources than by the owners.

In the second calculation it would

indicate that the business has more

interest-bearing debt than funding that

has been contributed by the owners.

In both cases, the lower the number, the

better for the lender.

Generally anything

higher than 1 is

regarded as risky and

the higher that number

goes, the riskier the

business becomes.

A business with a

higher gearing ratio is

often termed “highly

geared” or “highly

leveraged”.

Very often when calculating either of

these ratios, the total of any

intangible assets is deducted from

total shareholders’ equity.

The reason for this is simple;

when we analyse financial

information we tend to

disregard the value of

intangible assets because we

want to consider the value of

assets in a liquidation

scenario.

Should the business be

liquidated we would expect

that the intangible assets

would have no value (this

may not be true in reality but

we take a conservative

approach).

We know that if we reduce the value of

assets in the balance sheet we have to

make a corresponding adjustment to the

other side of the accounting equation

(because Assets = Equity plus Liabilities)

So we reduce the value of the total

shareholders’ equity by the amount of

intangible assets so that the balance

sheet will remain in balance.

Having said that a gearing ratio higher

than 1 would tend to indicate greater risk,

in reality, there is no one debt-to-equity

ratio that is regarded as optimal for all

types of businesses.

A very general guide is that those

businesses that require significant

levels of capital equipment (such as

plant and equipment, land and

buildings, vehicles etc) tend to have

higher levels of debt since these capital

assets are acquired using long-term

debt.

This often results in a relatively higher

gearing ratio and, while this does result in more risk, it’s certainly not unusual.

The reverse is true of

service-type businesses that

don’t require capital assets

and should not, therefore,

need high levels of long-

term debt.

Then you would expect to

see a relatively lower gearing ratio.

Although we might make a judgement

based on the gearing ratio, there is still

one thing to consider before doing so.

The point of the gearing ratio is to give us

a guide to the relative risk that the

business faces which is largely

dependent on the level of debt that it has

to service.

The point to consider, then,

is whether the debt is long-

term or short-term, since this

will affect our perception of

risk.

The shorter the term of the debt, the

more risk there is because the

business has to service and repay the

debt sooner, while the long-term debt

is usually less risky since all the

business has to do is to make the

contracted repayments.

What about preference

shares – are they debt or

are they part of total

shareholders’ equity?

On the balance sheet the value of any

preference shares issued will be found in

the capital section so it looks like they are

part of shareholders’ equity.

Much will depend on the terms of the

preference shares but, generally, they are

issued as a form of debt so a

conservative lender (aren’t we all?) would

probably consider them to be part of

interest-bearing debt.

What about shareholders’

loans – are they debt or

are they part of total

shareholders’ equity?

Well, of course, they

really are debt. The

shareholders in this

case have chosen to

inject funds into the

business by way of

loans rather than

share capital so their

intention to get those

funds back at some

point in the future is

fairly clear.

So, although they will normally appear in

the capital section of the balance sheet,

we should remove them from total

shareholders’ equity and add them to the

liabilities figure. Note that they may or

may not be interest-bearing.

But it would be better if we could regard

the shareholders’ loans as part of equity

because the amount that we can lend is

based on the level of equity in the balance

sheet.

We can achieve this by

having the shareholders

cede the loans to the lender

or by having them complete

a letter of subordination.

Alternatively we could insert

a covenant into the loan

agreement restricting their

repayment.

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