When you invest in a company you would like to know how secure that investment is. To a degree this information can also be valuable when trading a stock. A useful tool for making this assessment is a gearing ratio. There are several ways to make this calculation. How you do it will depend on the reason you are doing the calculation. So, what is the gearing ratio and how can we calculate it best? Our focus here has to do with investing and trading.
Understanding the Gearing Ratio and Its Importance
Gearing ratios are indicators of the degree of financial risk that comes with a company. Businesses with excessive debt always have the potential for having financial problems with even a slight drop in their business. High gearing ratios indicate financial risk caused by excessive debt. Low gearing ratios imply a much more secure financial situation. The reason is that a company has to pay back money that they borrowed. If all of their capital came from selling stock, stockholders may suffer but the company could be able to continue to operate during difficult times.
Breaking Down the Different Types of Gearing Ratios
There are four types of gearing ratios. These are the equity ratio, the debt to capital ratio, the debt service ratio, and the net gearing ratio. Each of these is calculated using a different formula. Equity ratio is simply equity divided by assets. A high equity ratio tells you a company has not borrowed a lot of money and it is very solvent. Debt to capital is debt divided by debt plus shareholder equity and is a good measure of financial leverage. The debt service ratio is a good measure of a company’s ability to fund its operations and is operating income divided by debt service. The net gearing ratio is the most commonly used by investors and is long and short debt plus overdrafts divided by shareholder equity.
Examining Examples of Calculating Gearing Ratios
The most commonly used gearing ratio is the net gearing ratio. The ratio is all debts and overdrafts divided by equity and you want to see a less than 25% result for a low risk investment and 25 to 50% for an average to moderate risk investment. You should be able to find the necessary information for this calculation in the company’s financial statements. Shareholder equity is total company assets minus total liabilities. Ideally this is what was initially invested in the company plus accumulated cash and other assets. In calculating the debt part it is important to know not only how much long and short term debt the company owes but also how far they are behind on payments including being overdue on any and all accounts.
Exploring the Impact of Leverage on Financial Statements
The importance of financial leverage goes hand in hand with the ability of a business to generate income. A company that virtually controls its business niche and is generating sales and income at a high rate can support a high debt load. Established businesses in established sectors with lots of competition generally get in trouble if they have too much debt. Investors are well advised to find out if the company’s debt is going up, going down or remaining stable. Along with that, the investor should find out if the company is bringing in more money, less money, or the same over time.
Analyzing the Benefits and Risks of Leverage for Companies
Do you want to invest in a company with very little debt compared to their assets and income? Or do you want to invest in a company with a lot of debt compared to their assets and income? We generally think that low leverage is a good idea, but that may depend on the type of business. Capital intensive companies should be investing in their growth. How well is the company performing and how well are they handling their debt over time? This is what you want to know in regard to whether a low or high gearing ratio is what you want to see.
Discovering How to Use Gearing Ratio Analysis to Make Better Financial Decisions
Successful long term investors only put money into a company when they fully understand what the company does to make money and how it will continue to make money far into the future. A tool like a gearing ratio can be part of the necessary analysis. For example, a healthy growing company may choose not to dilute the value of its stock shares. Thus they will borrow money with the expectation of paying it back with cash flow instead of issuing more shares for expanding their business.