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 future and so it is about deciding whether go for issue of shares or borrowing of funds as issue of equity will change the dilution and control and borrowing will increase finance cost.
Explanation
The sources of funds for an organization consisting of equity and debt. Equity is the investment by the owners against the issue of sharesIssue Of SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet.read more, and in return, owners get a share of profit. The higher the investment, the higher will be the share of profit and holding status. On the other hand, debt is the borrowings which may be from a bank or financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more or friends and relatives on the interest. The interest is the cost for the organization, and if interest increases, the return of shareholders decrease 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 to the best interest of the organization. It shows the extent of operations which are either funded by equity or by borrowings. Temporary requirements are managed by borrowings instead of equity.
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 as well through which it can be measured, but this is the most comprehensive ratio.
Here,
- Short term debt refers to the debt, which is to be repaid with a period of one year.
- Long term debt refers to the debt which is to be repaid after a period of one year.
- Capital lease refers to the lease where the only the lease is financed by the lessor while all the other rights related to the ownership of the property is with the lessee.
- Equity refers to the amount of capital raised from the shareholders of the company 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 debt which is payable by the company within the period of next year. It is shown under the head short term liability in the company’s 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 period of the next one year. It is shown under the head long term liability in the company’s 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 is with the lessee
Step #4
In this step amount of the shareholder’s equity in the company will be calculated. It is the amount of funds raised by issuing the preference shares and common shares. 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 –
- = ($800,000 + $500,000 + 0) / $1,000,000
- = 1.3
Reasons
- It determines the creditworthiness of the organization. Balanced debt to equityDebt To EquityThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more 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 leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more.
- Solvency can be better managed with proper financial gearing.
- The gearing ratio measures the impact of debt on equity and helps in managing financial riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more.
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 to 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—more the ratio greater the difficulty in obtaining loans.
- Proper financial gearing gives the tax benefits as interest is used as a tax-saving tool.
- It is one of the tools for investment decisions.
Disadvantages
- High gearing can increase the cost of the company as interest is the expenses 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, which ultimately increases the debt-equity ratio.
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