Capital Gearing Ratio: Formula and Explanation

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That means it’s not too exposed to economic changes because of its loans, but it’s also not too reliant on shareholders’ equity. The funding comes at a cost and that cost is the fact that a loan has to be repaid, which makes it a debt. Having debt isn’t a problem, but it can be if a company’s debt is high compared to the money it has from shareholders (aka equity). One common type of gearing ratio is a company’s debt-to-equity (D/E) ratio. When we’re assessing where a company gets its money from, we can look at lenders vs. shareholders.

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2. Lenders and investors pay close attention to the gearing ratio because a high ratio suggests that a company may not be able to meet its debt obligations if its business slows down.
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4. This means that with the limited cash flows that the company is getting, it must meet its operational costs and make debt payments.

This means that the company is more susceptible to economic downturns and may struggle to meet its debt obligations if profits fall. However, low equity gearing may also indicate that the company is taking advantage of the potential tax benefits of debt financing. A high gearing ratio can be a blessing or a curse—depending on the company and industry. Having a high gearing ratio means that a company is using more debt to fund its operations, which may increase the financial risk.

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Gearing is the amount of debt – in proportion to equity capital – that a company uses to fund its operations. A company that possesses a high gearing ratio shows a high debt to equity ratio, which potentially increases the risk of financial failure of the business. In contrast, companies with a high gearing ratio from a stable industry may not pose a serious threat to lenders and investors. Companies in this sector need high capital investments, and hence, their capital gearing ratio will be obviously high. However, they are the monopolies, and their rate is highly regulated. Capital gearing ratio acts as one of the major factors based on which lenders and investors consider a company.

At times, companies may increase gearing in order to finance a leveraged buyout or acquire another company. For example, if a company is said to have a capital gearing of 3.0, it means that the company has debt thrice as much as its equity. As an example, in order to fund a new project, ABC, Inc. finds that it is unable to sell new shares to equity investors at a reasonable price. Instead, ABC looks to the debt market and secures a USD $15,000,000 loan with one year to maturity. If a company can reduce working capital such as collecting money from the debtors soon, inventory levels etc. It is important that you understand that with investments, your capital is at risk.

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1. If we write out the formula, we can say that a gearing ratio is the total amount of debt divided by the amount of capital provided by shareholders.
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3. When the trading return on total funds invested exceeds the interest rate on loans, any residual surplus accrues to shareholders, enhancing their return.
4. For example, a startup company with a high gearing ratio faces a higher risk of failing.
5. In industries requiring large capital investments, gearing ratios will be high.

But if its main competitor shows a 70% gearing ratio, against an industry average of 80%, the company with a 60% ratio is, by comparison, performing optimally. Companies with high levels of capital gearing will have a larger amount of debt relative to their equity value. The gearing ratio is a measure of financial risk and expresses the amount of a company’s debt in terms of its equity. A company with a gearing ratio of 2.0 would have twice as much debt as equity.

We’ve already mentioned that there are many types of gearing ratios. We’ve also told you that a common type of gearing ratio is debt-to-equity. Don’t worry, you don’t have to be a math genius to perform these calculations. Anyone who has traded before will know that you always have to think about risk. It may be hard to calculate, but it’s always important to consider.

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

The capital gearing ratio is a solvency ratio which is a very helpful metric to evaluate the capital structure and financial stability of the company. A good capital gearing ratio is considered to be the individual company comparative to other companies within a similar industry. The capital gearing ratio is called financial leverage and analyses the financial ability of the company. The net gearing ratio is the most common gearing ratio used by analysts, lenders, and investors. Also called the debt-to-equity ratio, it measures how much of the company’s operations are funded by debt compared to its equity. Gearing ratios are financial metrics that compare a company’s debt to some form of its capital or equity.

A gearing ratio is a useful measure for the financial institutions that issue loans, because it can be used as a guideline for risk. When an organisation has more debt, there is a higher risk of financial troubles and even bankruptcy. Let’s say a company is in debt by a total of $2 billion and currently hold $1 billion in shareholder equity – the gearing ratio is 2, or 200%. This means that for every $1 in shareholder equity, the company has $2 in debt. A company may require a large amount of capital to finance major investments such as acquiring a competitor firm or purchasing the essential assets of a firm that is exiting the market. Such investments require urgent action and shareholders may not be in a position to raise the required capital, due to the time limitations.

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