Financial Gearing

Updated on May 10, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Financial Gearing?

Financial Gearing is the management of capital of the organizations by maintaining the proper proportion of debt and equity so that the organization should not face any problem in the future. So it is about deciding whether going for the issue of shares or borrowing of funds as an issue of equity will change the dilution and control, and borrowing will increase finance cost.

Key Takeaways

  • Financial gearing involves strategically balancing an organization’s capital structure between debt and equity to prevent future issues. 
  • Proper financial gearing allows for an assessment of the organization’s creditworthiness and helps determine whether borrowing or issuing shares is the more advantageous option. 
  • It also measures financial leverage and manages risk to ensure solvency.
  • Unbalanced financial gearing can increase risk, particularly when there is high gearing or excessive reliance on short-term borrowings. Interest expenses associated with debt can also significantly increase the company’s costs.

Explanation

The sources of funds for an organization consist of equity and debt. Equity is the investment by the owners against the issue of shares, and in return, owners get a share of profit. The higher the investment, the higher the share of profit and holding status will be. On the other hand, debt is the borrowing from a bank or financial institution or friends and relatives on the interest. The interest is the cost for the organization, and if interest increases, shareholders’ return decreases due to a decline in profit. So, there must be a balance between equity and debt, and financial gearing includes the management of the capital in the organization’s best interest. It shows the extent of operations funded by equity or by borrowings. Temporary requirements are managed by borrowings instead of equity.

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Formula

Financial-Gearing-Formula

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For eg:
Source: Financial Gearing (wallstreetmojo.com)

Financial Gearing Ratio = (Short Term Debts +Long Term Debts + Capital Lease) / Equity

There are other formulas through which it can be measured, but this is the most comprehensive ratio.

Here,

  • Short-term debt refers to the debt to be repaid within one year.
  • Long term debt refers to the debt to be repaid after one year.
  • Capital lease refers to the lease where the lessor finances only the lease while all the other rights related to the ownership of the property are with the lessee.
  • Equity refers to the amount of capital raised from the company’s shareholders through the issuance of the common shares or the preference shares.

How to Calculate Financial Gearing?

Step #1

Firstly, calculate the amount of money raised by the company through the short-term debt mode, i.e., the company’s debt payable within the next year. It is shown under the short-term head liability in the company balance sheet.

Step #2

After calculating the amount of short-term debt in step 1, calculate the amount of money raised by the company through the long-term debt mode, i.e., the debt which is payable by the company after the next year. It is shown under the long-term head liability in its balance sheet.

Step #3

After calculating the long-term liability in step 2, calculate the capital lease amount, i.e., the lease where the lessor only finances the lease, and all the other ownership-related rights of the property are with the lessee.

Step #4

The number of funds raised by issuing the preference shares and common shares. In this step, the amount of the shareholder’s equity in the company will be calculated. This amount will be shown under the shareholder’s equity section under the liabilities section of the balance sheet.

Step #5

The formula to calculate this ratio is as follows-

Financial gearing ratio is = (Short term debts + long term debts + Capital lease) / Equity

Example

Suppose a company, Amobi Incorporation wants to calculate its financial gearing, which has short-term debt of $800,000, long-term debt of $500,000, and equity of $1,000,000. How to calculate for the mentioned period?

Solution

Step by step calculation is given below-

Step #1

Calculation of short term debt

It is given as $800,000

Step #2

Calculation of long term debt

It is given as $500,000

Step #3

Calculation of Capital leases

It is not present in the present case

Step #4

Calculation of Equity

It is given as $1,000,000

Step #5

Calculation of Financial Gearing can be done as follows –

Financial Gearing Example
  • = ($800,000 + $500,000 + 0) / $1,000,000
  • = 1.3

Reasons

  • It determines the creditworthiness of the organization. Balanced debt to equity and timely repayments indicate high creditworthiness in the market.
  • It is a tool to analyze whether the borrowing will be beneficial or the organization should go for the issue of shares.
  • It is a measure of an organization’s financial leverage.
  • Solvency can be better managed with proper financial gearing.
  • The gearing ratio measures the impact of debt on equity and helps manage financial risk.

Advantages

  • Risk can be better managed with balanced gearing.
  • The proper balance between debt and equity can be maintained with the help of financial gearing management.
  • It helps determine the safety of funds more the ratio less safe the funds are and vice versa.
  • It helps to evaluate the financial health of the company.
  • It is one of the factors while sanctioning the loan—the more the ratio greater the difficulty in obtaining loans.
  • Proper financial gearing gives the tax benefits as interest is a tax-saving tool.
  • It is one of the tools for investment decisions.

Disadvantages

  • High gearing can increase the company’s cost as interest is the expense for the organization.
  • Unbalanced financial gearing can lead to an increase in risk.
  • Return on investment could be decreased due to unfavorable gearing, which leads to a decline in creditworthiness.
  • Even short-term borrowings are included in financial gearing, increasing the debt-equity ratio.

Frequently Asked Questions (FAQs)

1. What is operational gearing vs. financial gearing?

Operational gearing refers to the extent to which fixed costs are used in an organization’s operations. This means that a higher proportion of fixed costs leads to higher operational gearing. On the other hand, financial gearing refers to the use of debt in a company’s capital structure.

2. What is the difference between financial gearing and leverage?

Financial gearing and leverage are related concepts, but they refer to slightly different things. Financial gearing refers to the proportion of debt and equity in an organization’s capital structure. Leverage, on the other hand, refers to the use of debt to finance assets or operations.

3. Is financial gearing a liquidity ratio?

Financial gearing is not a liquidity ratio. Liquidity ratios are a group of financial ratios that measure a company’s ability to meet its short-term obligations. Financial gearing, on the other hand, is a measure of the balance between debt and equity in a company’s capital structure. It relates more to a company’s long-term financial health and its ability to manage its debt levels.

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