The document explains the concept of gearing ratio, which measures a business's reliance on debt versus equity for funding its assets. It discusses various definitions of debt used by lenders for calculating this ratio, their implications on risk assessment, and the importance of understanding the nature of the debt (long-term vs. short-term). Additionally, it highlights that the optimal gearing ratio varies by industry and provides guidance on interpreting these ratios and considering preference shares and shareholder loans in calculations.

1. Understanding the
gearing ratio
from
businessbankingcoach.com
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2. Gearing refers to the mix of debt and
equity funding that a business uses
to finance its assets. Gearing is also
known as leverage.
What is
gearing?

3. From a lender’s perspective,
we are interested in the
gearing ratio because it
reflects the degree to which
the business relies on funds
provided by outside sources
of finance (e.g. bank,
suppliers, etc.) in relation to
that provided by the owners.

4. But, how is “debt” defined in this context?
In fact, the definition of debt for
the purposes of calculating the
gearing ratio varies between
lenders.

5. Some banks consider debt to be the
same as total liabilities…….

6. Some lenders consider debt to be the
same as total liabilities…….. that is,
interest-bearing debt plus accounts
payable and other non-interest-bearing
current liabilities.
Other lenders take only interest-bearing
debt into consideration.

7. In deciding which definition to use, the
thing to ask yourself is ……“what do I
want the gearing ratio to tell me about?”
If you want to know how the
business funds it assets and
what degree of risk it takes in
doing so, you would look at
using the total liabilities
figure in the calculation.

8. But, if you’re a lender
and you want to know
what the business’
capacity for additional
bank debt is, you
would use the
interest-bearing debt
figure.

9. Obviously, you
might want to
have both these
pieces of
information so
you might use
both ratios
in your
assessment

10. Gearing =
Total liabilities
Total shareholders’ equity
Gearing =
Total interest-bearing debt
Total shareholders’ equity
Depending on which ratio is to be used,
the formula will be;
or

11. Where the outside
sources of funding
(i.e. the liabilities or
debt) exceed the
owners’ equity, the
gearing ratio will be
1 or higher

12. If the resulting ratio is higher than 1, in
the first of those calculations this will
indicate that more funding is provided by
all outside sources than by the owners.
In the second calculation it would
indicate that the business has more
interest-bearing debt than funding that
has been contributed by the owners.
In both cases, the lower the number, the
better for the lender.

13. Generally anything
higher than 1 is
regarded as risky and
the higher that number
goes, the riskier the
business becomes.
A business with a
higher gearing ratio is
often termed “highly
geared” or “highly
leveraged”.

14. Very often when calculating either of
these ratios, the total of any
intangible assets is deducted from
total shareholders’ equity.

15. The reason for this is simple;
when we analyse financial
information we tend to
disregard the value of
intangible assets because we
want to consider the value of
assets in a liquidation
scenario.

16. Should the business be
liquidated we would expect
that the intangible assets
would have no value (this
may not be true in reality but
we take a conservative
approach).

17. We know that if we reduce the value of
assets in the balance sheet we have to
make a corresponding adjustment to the
other side of the accounting equation
(because Assets = Equity plus Liabilities)
So we reduce the value of the total
shareholders’ equity by the amount of
intangible assets so that the balance
sheet will remain in balance.

18. Having said that a gearing ratio higher
than 1 would tend to indicate greater risk,
in reality, there is no one debt-to-equity
ratio that is regarded as optimal for all
types of businesses.

19. A very general guide is that those
businesses that require significant
levels of capital equipment (such as
plant and equipment, land and
buildings, vehicles etc) tend to have
higher levels of debt since these capital
assets are acquired using long-term
debt.
This often results in a relatively higher
gearing ratio and, while this does result
in more risk, it’s certainly not unusual.

20. The reverse is true of
service-type businesses that
don’t require capital assets
and should not, therefore,
need high levels of long-
term debt.
Then you would expect to
see a relatively lower
gearing ratio.

21. Although we might make a judgement
based on the gearing ratio, there is still
one thing to consider before doing so.
The point of the gearing ratio is to give us
a guide to the relative risk that the
business faces which is largely
dependent on the level of debt that it has
to service.

22. The point to consider, then,
is whether the debt is long-
term or short-term, since this
will affect our perception of
risk.

23. The shorter the term of the debt, the
more risk there is because the
business has to service and repay the
debt sooner, while the long-term debt
is usually less risky since all the
business has to do is to make the
contracted repayments.

24. What about preference
shares – are they debt or
are they part of total
shareholders’ equity?

25. On the balance sheet the value of any
preference shares issued will be found in
the capital section so it looks like they are
part of shareholders’ equity.
Much will depend on the terms of the
preference shares but, generally, they are
issued as a form of debt so a
conservative lender (aren’t we all?) would
probably consider them to be part of
interest-bearing debt.

26. What about shareholders’
loans – are they debt or
are they part of total
shareholders’ equity?

27. Well, of course, they
really are debt. The
shareholders in this
case have chosen to
inject funds into the
business by way of
loans rather than
share capital so their
intention to get those
funds back at some
point in the future is
fairly clear.

28. So, although they will normally appear in
the capital section of the balance sheet,
we should remove them from total
shareholders’ equity and add them to the
liabilities figure. Note that they may or
may not be interest-bearing.

29. But it would be better if we could regard
the shareholders’ loans as part of equity
because the amount that we can lend is
based on the level of equity in the balance
sheet.

30. We can achieve this by
having the shareholders
cede the loans to the lender
or by having them complete
a letter of subordination.
Alternatively we could insert
a covenant into the loan
agreement restricting their
repayment.

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