Financial Gearing

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

Financial-Gearing-Formula

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
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,

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 Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more.

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 –

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

Reasons

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.

Recommended Articles

This article has been a guide to Financial Gearing Ratio and its definition. Here we discuss formula, example, and how to calculate financial gearing along with advantages and disadvantages. You may learn more about excel from the following articles –