When you think about a business, it’s important to understand how it gets its money and how it spends it. One key factor in understanding a business’s financial health is the gearing ratio. This is a simple number that helps to show how much money a company owes compared to how much it owns.
If you’re new to finance, don’t worry! We’ll break down what the gearing ratio is, how it’s calculated, why it’s important, and how it helps everyone from business owners to investors and banks.
What Is the Gearing Ratio?
The gearing ratio is a financial measure that compares the amount of money a company owes (its debt) to the amount it owns (its equity).
- Debt is money that the company has borrowed and needs to pay back.
- Equity is the value of the company’s assets that belong to the owners or shareholders. It’s the company’s own money, not borrowed.
The gearing ratio shows how much of a company’s business is funded by borrowing compared to the company’s own money.
A high gearing ratio means the company owes a lot of money (it’s heavily in debt). A low gearing ratio means the company is using more of its own money and less borrowed money.
Why Is the Gearing Ratio Important?
The gearing ratio is an important tool for understanding how risky a business is. It helps you see if a company is in a strong financial position or if it could have problems with its debt.
- For Lenders (like banks): Banks use the gearing ratio to decide whether they want to lend money to a company. If a company already owes a lot, the bank might think it’s a risky investment and could charge higher interest rates or refuse to lend more money.
- For Investors: Investors also use the gearing ratio to understand how risky it is to invest in a company. If a company has a lot of debt, it could be more likely to face financial problems, so it might be a risky investment. On the other hand, a company with less debt might be safer but could offer lower returns.
- For Companies: If you run a business, knowing your gearing ratio helps you make decisions about how to finance your company. Should you borrow more money, or should you get more money from your owners or shareholders?
How to Calculate the Gearing Ratio
Don’t worry, calculating the gearing ratio is easy! You just need two things: debt and equity.
Here’s the simple formula:
Net Gearing Ratio = (Long-Term Debt + Short-Term Debt + Bank Overdrafts) ÷ Shareholders’ Equity
Let’s break it down:
- Long-Term Debt: Money borrowed for a period longer than one year.
- Short-Term Debt: Money borrowed for a period of less than one year.
- Bank Overdrafts: Short-term loans from the bank to cover immediate expenses.
- Shareholders’ Equity: The value of the company’s assets (what it owns) minus its debts. This is the money that belongs to the company’s owners or shareholders.
Example of How to Calculate the Gearing Ratio
Let’s say a company has the following:
- Total Debt: ₹500,000
- Shareholders’ Equity: ₹1,000,000
Now, we use the formula:
Net Gearing Ratio = ₹500,000 ÷ ₹1,000,000 = 0.5 or 50%
This means that for every ₹1 of money the owners have invested, the company has ₹0.50 of debt. A ratio of 50% means the company uses some debt, but it’s not too reliant on it.
What Is a Good Gearing Ratio?
Once you calculate the gearing ratio, it’s helpful to know what is considered good or bad. A gearing ratio can give you a sense of how safe or risky the company’s financial situation is. Here’s a simple guide:
- Low Gearing Ratio (below 25%): If the ratio is low, it means the company uses more of its own money and less borrowed money. This is generally considered safe because the company has less debt to worry about.
- Moderate Gearing Ratio (25% to 50%): A moderate ratio means the company has a good balance between debt and equity. It’s not too risky, and not too safe. This is a normal and balanced financial position.
- High Gearing Ratio (above 50%): A high ratio means the company relies a lot on borrowed money. While borrowing can help a company grow faster, it also means there’s a higher risk. If things don’t go well for the company, it could struggle to pay off its debt.
Why Do Lenders and Investors Care About the Gearing Ratio?
- Lenders: Banks and other lenders use the gearing ratio to figure out how risky it is to lend money to a company. If a company already has a lot of debt (high gearing ratio), the lender might think it’s risky to lend more money. They may even refuse to lend or ask for higher interest rates.
- Investors: Investors want to make money from their investments, but they also want to avoid losing money. A company with a high gearing ratio might be risky because it owes a lot of money. However, if the company is using debt wisely to grow quickly, some investors might still see it as an opportunity for bigger returns.
How to Lower the Gearing Ratio
If a company’s gearing ratio is too high (meaning it has too much debt), there are a few ways to lower it:
- Pay Off Debt: The simplest way to reduce the gearing ratio is to pay back some of the money the company owes. This reduces the total debt and lowers the ratio.
- Raise More Equity: A company can also ask its shareholders to invest more money. By selling more shares or bringing in new investors, the company increases its equity and reduces the debt-to-equity ratio.
- Increase Profits: When a company makes more money (profits), it increases its equity. This can help lower the gearing ratio over time.
Conclusion
The gearing ratio is a simple but powerful tool to help understand how much debt a company has compared to its own money. A low gearing ratio suggests the company is in a safer financial position, while a high gearing ratio means the company could be taking on more risk by relying heavily on debt.
By calculating and understanding the gearing ratio, business owners can make better financial decisions, investors can assess whether a company is a good or bad investment, and lenders can decide whether to lend money.
In the end, the gearing ratio is about balance. It’s about finding the right amount of debt to help the company grow without taking on too much risk. Keep an eye on the gearing ratio to help make informed decisions about money and business!
