Financial gearing definition
/What is Financial Gearing?
Financial gearing refers to the relative proportions of debt and equity that a company uses to support its operations. It measures the ratio of debt to equity or total capital, indicating how much of the company’s activities are funded by borrowed money compared to shareholders’ funds. High gearing means a business has a greater proportion of debt, which can amplify returns when times are good but also increases financial risk if earnings decline. Low gearing indicates a more conservative capital structure with less reliance on external borrowing. Gearing is a key indicator of financial stability and risk exposure.
How to Calculate Financial Gearing
The calculation used for financial gearing is to add together all forms of debt and then divide by the total amount of equity. The formula is:
(Short-term debt + Long-term debt) ÷ Equity = Financial gearing
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Example of Financial Gearing
ABC International is unable to sell any additional shares to investors at a reasonable price to fund its expansion, and so obtains a $10,000,000 short-term loan instead. The company currently has $2,000,000 of equity, so there is now a 5x ratio of debt to equity. The company would most definitely be considered highly geared.
Advantages of Financial Gearing
There are several reasons why a business might use financial gearing, as noted below:
Avoid dilution. The current owners do not want to dilute their ownership by issuing shares to any new investors, so debt is the only remaining alternative for raising funds. This is most commonly used in a closely-held business, such as one that is owned by a family. Alternatively, it may be used when the investment community is only willing to buy shares at a very low price, which occurs when a business is reporting poor profitability.
Raise cash. A company needs a large amount of cash right now, perhaps for an acquisition, and cannot raise sufficient cash from investors to meet its requirement. Alternatively, a company is suffering a cash shortfall from its operations, and needs additional cash to bolster its operations. In the latter case, lenders will perceive a high repayment risk, and so will impose a hefty interest charge.
Increase return on equity. A company wants to increase its return on equity measurement, and can most easily do so by using new debt to buy back shares from investors. This is essentially a balance sheet manipulation, which does not provide any real benefit to the organization.
Disadvantages of Financial Gearing
A major downside of financial gearing is that the cost of the debt could increase, due to changes in market rates. Or, a company is achieving an insufficient return on its use of the funds, and so cannot pay for the interest or the return of principal. In either case, excessive gearing presents a significant risk of bankruptcy. This is a particular problem during an industry downturn, when cash flows inevitably decline. Consequently, the use of financial gearing must be prudent, to allow for some use of additional funds while not putting a business in jeopardy.
Users of Financial Gearing Information
Users of financial gearing information include investors, lenders, company management, analysts, and shareholders, all of whom rely on this data to assess financial risk and stability. Investors use gearing to evaluate the risk-return profile of a company, while lenders assess it to determine the firm’s ability to meet debt obligations. Company management monitors gearing to make strategic funding decisions and maintain a balanced capital structure. Financial analysts and regulators use it to gauge broader market health and identify over-leveraged firms. Shareholders are interested in gearing because it influences profitability, dividend potential, and overall investment risk.