Definition
Financial gearing, often referred to as leverage, is a measure of a company’s financial leverage and shows the ratio of the company’s debt to its equity. A company with high financial gearing has a larger proportion of debt than equity which may be riskier, but can lead to higher returns in profitable times. On the other hand, a company with low financial gearing is more equity financed, which can be deemed safer, but may lead to lower returns.
Key Takeaways
- Financial Gearing refers to the level of a company’s debt related to its equity capital, usually expressed in percentage form. It is used to assess the financial health and liquidity of a company.
- High Financial Gearing indicates a high level of debt, showing that a company has aggressively financed its growth with debt. This can lead to more earnings volatility and higher risk of default.
- Low Financial Gearing, on the other hand, represents that a company predominantly uses equity for financing its operations. These companies are often seen as safer, but they might not be taking full advantage of the cost benefits of borrowing.
Importance
Financial gearing is vital since it provides insight into a company’s leverage measured by the proportion of its activities funded by owner’s funds versus borrowed funds.
A higher gearing ratio indicates greater financial risk due to the higher dependence on borrowed money, which can impact interest expenses and vulnerability to market interest rate fluctuations.
Conversely, lower gearing signifies less reliance on debt, meaning lower financial risk but potentially slower growth due to less available capital.
Therefore, understanding financial gearing allows investors and stakeholders to evaluate a company’s financial stability, funding strategies, and risk level, influencing investment decisions and perceptions of the company’s financial health.
Explanation
Financial Gearing, commonly known as leverage, typically serves the purpose of determining the degree to which a business’s operations are funded by debt versus equity. Its main function is to provide an indication of the company’s financial risk and how sustainable its business operations are, especially during challenging financial times.
If a company has high financial gearing, it indicates that a large portion of its capital is generated from debt. This can potentially pose higher risks as the company has ongoing obligations to meet repayments with interest.
High gearing may also signal to potential lenders that the company already possesses significant liability, thereby potentially affecting the company’s ability to obtain further financing. On the other hand, if the firm is equipped with a sound revenue stream and stable cash flows, the high leveraging can be used to enhance profitability by borrowing at a lower interest rate than what they earn on their assets.
Thus, the idea behind financial gearing is to provide insights into a company’s financial structuring, helping investors make informed decisions about a company’s risk and return profile.
Examples of Financial Gearing
Financial gearing, also known as financial leverage, refers to the borrowing of funds in order to finance the assets or operations of a company. It is the ratio of debt used in the capital structure to the shareholder’s funds or equity.
Real Estate Development: A property development company might use financial gearing when developing a new residential complex. The company does not necessarily have all the required funds on hand, so they seek a loan from a bank or a financial institution. They use the loan to pay for the development costs and expect to repay the loan and make profit once the houses or apartments are sold. Here, the development company uses financial gearing as a strategic tool to maximize returns while using someone else’s money.
Automobile Industry: A car manufacturing company might use financial gearing to start the production of a new model or to expand their existing manufacturing facilities. They can get loans or issue bonds for this purpose, with the expectation that the new model or increased production will generate profits which can cover the loan repayment or bond interest.
Telecommunication Companies: Telecommunications companies often have large capital expenditures due to the high cost of physical infrastructure, such as cell towers and fiber cables. In order to fund these large projects, they might rely on financial gearing, borrowing funds or issuing bonds. These debts can be manageable due to the steady cash flow provided by their consumer subscriptions and contracts. In each of these cases, financial gearing allows the companies to take on projects or make purchases they might not otherwise be able to afford, with the understanding that the resulting increase in business will allow them to repay their debts.
FAQs on Financial Gearing
Q1: What is financial gearing?
Financial gearing is a measure of a company’s financial leverage, which represents the proportion of its capital that comes from debt as contrasted with equity. It is a way to assess the financial risk of an organisation.
Q2: How can financial gearing be calculated?
Financial gearing is calculated by dividing long-term debts by the equity capital of the company. It can also be computed by taking the company’s debts (both long-term and short-term) and dividing them by the company’s total capital.
Q3: Is a high financial gearing ratio risky?
A high financial gearing ratio indicates that a significant proportion of the business’s capital comes from borrowed funds, which can be risky. This is because an organization with high gearing needs to service its debts regardless of business performance, increasing vulnerability to downturns in the market or rises in interest rates.
Q4: How can a company reduce its financial gearing ratio?
A company can reduce its financial gearing ratio by either decreasing its debt or increasing its equity. Debt can be reduced by paying off loans or other obligations, while equity can be increased through retained earnings or the issuance of new shares.
Q5: What are the potential advantages of high financial gearing?
While it can be associated with increased risk, high financial gearing can also offer certain advantages. When interest rates are low or the company can earn a higher rate of return on borrowed funds than the interest rate on the debt, financial gearing can serve to increase the return on equity for the company’s shareholders.
Related Entrepreneurship Terms
- Debt Ratio
- Equity Ratio
- Capital Structure
- Leverage
- Interest Coverage Ratio
Sources for More Information
- Investopedia: This platform offers a wealth of information on various financial concepts, including financial gearing.
- Khan Academy: A non-profit educational organization that provides free online courses, including finance and capital markets.
- Corporate Finance Institute: Offers a range of online finance courses and certifications. It has resources that explain the concept of financial gearing.
- The Balance: Provides expertly crafted financial information and advice on various concepts, including financial gearing.
