Gearing Ratios Explained – How to Use Leverage Analysis for Your Small Business
In the final post in our series on ratios and KPIs we’re looking at gearing ratios!
So, hop in, take the wheel and get into gear, because this is going to be a wild ride through some of the most tortured analogies in finance.
Gearing is another one of the terms I never really understood when I started out in financial planning.
I thought, “Ah, these experts, they’ve just chosen a word that sounds simple! I bet gearing has nothing to do with gears! I mean, how could it? My business isn’t a bike or a car.”
And it’s true – gearing sounds deceptively mundane. But it really does have something to do with gears!
In this guide I’m going to take you through the definitions of the most common gearing ratios and explain each equation step-by-step.
But first, it’s worth spending a moment to understand what gearing is trying to do – and why it is, in fact, about gears.
We all know what a gear is, or at least, how to use one. Bikes have gears, cars have gears. From a driver’s perspective, gears are about speed management and efficiency. Changing to a higher gear makes it easier to go faster over flat ground while changing to a lower gear makes it easier to go uphill. The phrase “changing gear”, or “shifting up a gear” carries the nuance of these mechanical actions – it’s not just a change in speed, it’s a change in the efficiency of moving at that new speed. It’s about how well the vehicle is using the power generated by its engine to move forward.
And this is very much how gearing can be thought about in relation to business planning.
What does gearing mean for businesses?
How highly “geared” a business is depends on how much of its funding comes from debt (such as loans) as opposed to shareholders’ equity in the business. The analogy is: a business is operating in a high gear if it is making great use of borrowed capital. Borrowing more, in theory, means the business can spend more on making a success of itself. By comparison, a business is in low gear if it isn’t borrowing much, but is just using the money invested in it by its owners (shareholders) to move forward.
Highly geared businesses
The upshot of this is – a highly geared business can make a lot of headway in good times – they have a lot of capital and (hopefully) a plan to use this capital fruitfully. However, if the market changes or for any reason the businesses’ usual operations cease to be viable, this could spell disaster, as the business is now stuck with a lot of debt that it must repay.
As a result, highly geared businesses are often seen as being “high risk, high reward”, however, this isn’t a complete picture.
In particularly stable sectors, where the market is unlikely to be heavily disrupted by new technologies or trends, being highly geared can be the norm. Some very large corporations can also sustain long periods of high gearing as their very scale grants them resilience to changes in the market. Being a household name is seen as a mitigating factor, set against the risk that being funded primarily by debt incurs. However, in a post “too big to fail” age, debt is still an important metric for these organisations.
That’s enough for now about highly geared businesses, what about those operating in “low gear”?
Lowly geared businesses
Instead of being funded primarily by debt, these businesses are funded by the money invested into them by their shareholders. Such businesses are considered ‘low gear’ because the have elected not to increase their spending in the short term through borrowing. While this means they don’t necessarily have the same capacity for rapid growth as highly geared businesses, they are at much less risk of changes in their marketplace or economic downturns as they do not have large arranged debts that they need to pay to continue their activities.
In addition to the well-worn analogy of gears, this concept is sometimes called “leverage”. Businesses which use debt to fund their activities are considered to be “highly leveraged” or have “high leverage”. The idea being that the bigger the lever you use, the greater the force that you can exert. Just as a lever “amplifies” strength, it amplifies the results the business can expect from its activities. The more capital the business has access to, the more growth activities it can fund.
So, I hope that clears up what the gearing concept is all about – let’s get on to the actual ratios!
Gearing formula definitions
Gearing, or leverage, looks at the capital structure of a business. Gearing broadly asks the question, “how risky is this business?” There are several gearing ratios that help to answer this by looking at different relationships between the business’ debts, assets and earnings and equity.
One of the functions of gearing analysis is to offer information to lenders who wish to know how risky it is for them to lend to the company. But gearing ratios are also useful internally for the company itself, as a measure of how susceptible it would be to bad economic conditions or a changing marketplace. Unlike profitability ratios, gearing looks at the potential risks inherent in the way the company is funded. Having a great gearing ratio doesn’t make for a successful, profitable company! Other KPIs, like profitability and liquidity ratios, are needed to give a fuller picture of the business’ financial health.
Debt to Equity Ratio
Sometimes simply called the “Gearing Ratio”, debt to equity gets to the heart of gearing. It asks the question, “what is the ratio of the company’s debts to its equity.” Or to put it another way, “how much debt does the business have compared to its equity?”
Debt to Equity ratio =
Liabilities / Equity
Both liabilities and equity can be found on the Balance Sheet. When forecasting Debt to Equity ratio take the total liabilities for the month and divide them by the total equity for the month, then repeat this process for each month of the forecast to see a trend.
Times Interest Earned (TIE)
This ratio looks at the company’s ability to pay the interest on its debts. This is often calculated over a year, to see how many times over the company can afford to pay the interest due on its debts in that year.
Times interest earned =
Earnings before Interest and Taxes (EBIT) / interest payable on debts
Generally, a low Times Interest Earned ratio is bad, and a high one is good. A low ratio shows that the businesses’ earnings may not be able to cover its debts, while a high ratio shows that the business’ earning can cover its debts many times over.
Equity Ratio (Shareholder Equity Ratio)
This ratio shows how much money shareholders will receive if a company liquidates its assets. It is expressed as a percentage.
Equity Ratio (Shareholder Equity Ratio) =
(Shareholder Equity + Retained Earnings) / Total Assets
Shareholder Equity, Retained Earnings and Total Assets can be found on the Balance Sheet. When forecasting this ratio, a higher ratio indicates that investors can expect a greater return should a company liquidate its assets.
Do note that if a company goes bankrupt it pays debtors before shareholders!
Also called the Debt to Total Assets ratio. I bet you can guess what it consists of? This ratio is usually expressed as a percentage. This measures a company’s ability to meet its obligations (its liabilities) through its assets.
Debt Ratio =
Total debt (Liabilities) / Total Assets
The higher the percentage of debt to total assets, the higher the potential risk of the company not being able to meet its obligations.
Again, different industries can have very different ‘normal’ values for the debt ratios. Stable industries or very well established companies tend to have higher debt ratios.
Profitability, liquidity, gearing… What’s next?
I hope you have enjoyed this series on financial ratios and KPIs! The next steps for us at Brixx is going to be to add all of these metrics to a brand new KPI report, that will automatically calculate based on the financial models you have already been building in Brixx. If you’ve not joined Brixx yet – take a look at our free trial…