Financial Data
Updated 30 Sep 2020

Understanding how gearing ratios works

How to use someone else’s money to grow your business.

06 August 2012  Share  0 comments  Print

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Here is a guide to gearing, how it can be used to grow your business, and how it is measured.

A gearing ratio is a financial ratio that compares some measure of owner's equity to borrowed funds. Gearing, as a financial term, is a comparison of how much of a business’s activities are funded by borrowed funds as compared to owner's funds.

As such, the gearing ratio is a measure of the firm's financial leverage or risk. It is also an indirect measure of the company's business risk. For new businesses and franchises the norm is anything between 30% and 50% own contribution which means a gearing ratio of anything from 1:1 to 1:2.

Financial risk is the additional risk a business faces when it finances a portion of its assets with debt financing. Businesses have the option of buying their assets by going into debt or by using the money provided by people who have invested in the business.

In many small businesses, debt financing may be used exclusively since the business may not have any investors. When debt financing is used, the financial risk of the company increases. Companies cannot use 100% debt financing as that would constitute bankruptcy.

Gearing Ratio, Interest Payments, Other Fixed Payments

Financial gearing measures the risk that the company cannot meet the interest payments on its debt and its other fixed costs, such as lease payments.

If a company has to struggle to have enough cash on hand to pay its interest payments on debt and other fixed costs like lease payments, then it either has too much debt or too little cash flow. Firms can measure if they have too much debt by looking at industry average financial ratios.

If you have only interest payments, calculate the times interest earned ratio:

times interest earned = earnings before interest and taxes/interest = # of times

The times interest earned ratio tells you how many times over the business can pay its interest payments on debt. The higher the TIE ratio, the more liquid the firm and the less debt it has.

If you have interest payments to make plus other fixed charges such as lease payments, then you should calculate the fixed charge coverage ratio:

fixed charge coverage = earnings before interest and taxes + other fixed charges/interest + other fixed charges = # of times

The fixed charge coverage ratio tells you how many times over the business can pay its interest payments on debt, lease payments, and other fixed charges. The higher the fixed charge coverage ratio, the more liquid the firm and the less debt and fixed charges the firm has.

The Gearing Ratio: Debt and Equity

The ratio is another debt ratio that measures the long-term solvency of a business. It measures how well a company can meet its interest expense obligations.

For example, if a company owes interest on its long-term loans or mortgages, the times interest earned ratio can measure how easily the company can come up with the money to pay the interest on that debt.

The calculation of the times interest earned ratio is as follows:

times interest earned = EBIT/I = number of times

The number of times indicates how well the firm meets its interest obligations. The higher the number, the better the firm can pay its interest expense on debt. If the TIE is less than 1.0, the firm cannot meet its total interest expense on its debt.

Usually, if the debt to assets ratio is high, you will find that the times interest owned ratio is low since the business has a lot of debt.

Long-Term Debt to Total Capitalisation Ratio

Ideally the figure should always be greater than 1, which would indicate that there are sufficient assets available to pay liabilities, should the need arise. The higher the figure the better.

Industry averages

Certain industries have specific averages because of the way they are structured:

  • Transport:Where the majority of assets are tangible fixed assets, a figure of 0.6 would be acceptable.
  • Retail and manufacturing:Expect figures between 1.1 and 1.6
  • Wholesale and construction:Expect figures between 1.1 and 1.5
  • Motor vehicles:Expect figures between 1.2 and 1.6

Generally where credit terms and large stocks are normal to the business, the current ratio will be higher than, for example, a retail business where cash sales are the norm.

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