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.
Table of contents
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 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 the share of profit and holding status will be. On the other hand, debt is the borrowing 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, 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
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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 debtLong Term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more refers to the debt to be repaid after one year.
- Capital leaseCapital LeaseA capital lease is a legal agreement of any business equipment or property equivalent or sale of an asset by one party (lesser) to another (lessee). The lesser agrees to transfer the ownership rights to the lessee once the lease period is completed, and it is generally non-cancellable and long-term in nature.read more 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 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 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 –
- = ($800,000 + $500,000 + 0) / $1,000,000
- = 1.3
Reasons
- It determines the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more 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 manage 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 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)
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.
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.
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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