Financial gearing ratios are a set of measures that assess the proportion of a company’s finance that is provided by long-term debt. They are often used to measure a company’s liquidity and exposure to risk, since high borrowing can be risky for businesses, as repayments and interest might not be affordable in future.
But although gearing can be related to risk, it’s important to note that debt isn’t always a negative for growing businesses. If your company has strong, predictable revenues, then debt can be a useful source of funding for development and expansion.
In this article, we’ll explore how to use financial gearing ratios to understand how debt is affecting a company’s liquidity, and what this means for overall risk.
What does gearing mean for businesses?
Financial gearing refers to relative amounts of debt and equity that a company uses to support ongoing business operations.
“The financial gearing ratio measures how high debt is, in relation to equity, and a high ratio suggests a company relies on large amounts of debt to operate,” says Gary Hemming, an independent commercial finance advisor.
Understanding the financial gearing ratio of a business can provide useful insight, especially when comparing against other businesses in the same industry.
Highly geared businesses
A highly geared business is one with higher debt and higher gearing ratios. Typically, a gearing ratio of 50% or more is considered highly geared or 'highly leveraged'. However, in some industries such as telecoms, where businesses need to buy expensive machinery upfront, a highly geared business is perfectly normal.
“Higher gearing isn’t necessarily a mark of impending business failure,” says Hemming. “Highly geared businesses will generally face more risk than lower geared peers in the same industry. If a company relies on high gearing, then this generally means you’re more exposed to interest rate and liquidity risks.”
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Low geared businesses
Having a low gearing ratio suggests that a business is not reliant on external funding to finance operations, and the company is less exposed to risks such as missing repayments and interest rate rises.
However, it may also indicate that a company is not growing as quickly as it could, adds Hemming. “Without external funding, it can be hard for a company to take advantage of all opportunities to drive growth and profitability.”
Gearing ratio formula
A gearing ratio formula measures a firm’s total debt and then compares it to a form of assets, such as capital or equity.
Debt to equity ratio
The debt to equity ratio is a measure of how much debt a company has taken on to finance operations compared to the level of equity that is available. Equity is the net value of the company to shareholders if all assets were liquidated. A healthy debt ratio is generally around 1:1.5, meaning for every £1 a company takes on in debt, there should be £1.50 in equity.
Hip Pop makes gut-friendly drinks that are an alternative to mainstream soft drinks. The company has seen its revenue double each year for the last three years, and has enjoyed rapid global expansion.
Funding this growth meant balancing debt and equity financing, says co-founder Emma Thackray. “Debt financing isn’t always easy to access as an SME because you don’t have the trading history," she says. "But where we use it, we are always conscious of balancing it with the available equity.
“Our early funding came from angel investors, but debt financing allows us to fund business operations without giving away more equity through equity finance, and thus retain a healthy debt to equity ratio.”
Gearing ratio example
A gardening supply company has one long-term financing agreement for £200,000 and a mortgage loan of £1 million. The company has £3m in equity. We can calculate their gearing ratio as follows:
Debt to Equity Ratio = Total Liabilities (£1.2m) / Total equity (£3m)
Using this formula, the company’s gearing ratio is 0.4, or 40%. In other words, for every £1 of assets, the company has 40p of debt.
What is a good gearing ratio percentage?
“There’s no one size fits all figure that makes a business highly geared, and no ‘correct’ debt to equity ratio,” says Hemming. Instead, it’s important to consider gearing for any business compared to the industry average. “By looking at a company’s peers, it’s easy to create simple benchmarking,” he says.
For example, industries like recruitment and haulage typically rely on invoice financing and might borrow up to 95% of outstanding invoices at any one time. “While this is totally normal for those industries, it would be seen as a red flag in other sectors,” Hemming adds.
How to reduce gearing
The simplest way to reduce a gearing ratio is to rely on less debt to fund operations. This might mean repaying existing debt, or using other forms of financing, such as securing angel investment, like Hip Pop.
Limitations of gearing ratios
The key limitation of gearing ratios is that they must be viewed in the context of a particular industry. “Companies could be facing enormous risk or no risk at all, while having the same gearing ratio,” says Hemming. For example, a business that has a monopoly in a certain sector has less risk than one with the same gearing ratio but many direct competitors.
In addition, some companies could be struggling for finance and facing substantial risk without having any debt at all – in which case a gearing ratio could be misleading.
How does a high gearing ratio impact lending?
If a company’s gearing ratio is low, compared to its competitors, then it’s likely to make it easier to secure additional investment, including additional debt financing. A company that appears to be over-leveraged is likely to find it harder, or more expensive, to secure this funding.
What does the gearing ratio say about risk?
A higher gearing ratio indicates higher risk because if interest rates increase, then profit margins can be squeezed very easily, says Hemming. “Equally, where revolving debt is used to support cash flow, should that debt become less available (either a lower amount, or a delay in getting funds), there is often an immediate hole in cash flow,” he says.
Long-term debt can provide a viable and affordable way to fund business operations. However, this should be managed with an awareness of the ongoing gearing ratios. Should a gearing ratio start to rise outside of industry norms, this is an indication that a business could be at risk from unexpected increases in costs, for example in its supply chain, or a drop in revenue.
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