The gearing ratio measures the proportion of funds borrowed by a company to equity. It is calculated as the total loan (liabilities of the long and short-term included in this loan) divided by total equity of the shareholder. This is an important term used in bookkeeping. A specific formula is used to calculate gearing ratio in bookkeeping.
It is the amount of equity needed to pay outstanding debts. Low gearing is the best option for SMEs because a company that has 10% gearing ratio would be able to pay off debts more quickly and investors consider it a low-risk company. Also, while companies with high gearing ratio around 50% or above are considered a greater risk because they could be defaulters or bankrupts if profits are declined for small periods of time or rates of interest increased.
To evaluate the financial fitness of a company, gearing ratio is one of the most common tools. The formula to calculate gearing ratio in bookkeeping is as follows
Gearing ratio formula = Debt / (Debt + Equity)
Types of Gearing
- Financial gearing
- Operational gearing
1. Financial Gearing
Financial gearing includes using debt for funding a business.
The risk is increased by financial gearing though returns are raised. The debt is a risk for the business. It is a relationship among loan and equity i.e. how a business is funded.
2. Operational Gearing
This term is used less commonly. It is the relationship between fixed costs and variable costs of the business.
Disadvantages of Higher Gearing Ratio
Higher gearing ratio is suggestive of an abundant deal of leverage when an SME is consuming debt to pay for its ongoing operations. In a trade recession, such SMEs may face distress while meeting schedules of their debt and are at risk of bankruptcy. The condition is particularly risky when a firm involves in debt engagement interest rates which are with variable because a sudden rise in rates could lead to serious problems in the payment schedule.
A regulated industry such as utilities is not as affected by this. They have the monopoly in business and regulatory authorities will increase the rate to cover the gap and ensure their continued survival. Possible requirements by financiers to lessen this problematic situation are the usage of restricting agreements that disallow the payment of shares, enforce extra cash flow into debt repayment, constraints on substitute usages of cash, and conditions for shareholders to place additional equity into the firm. Creditors have the similar concern but are commonly incapable of enforcing alterations on the conduct of the firm.
SMEs which require large fixed assets have higher gearing ratio. A company with low gearing ratio may be managing finances with a conservative approach. However, it may be indicative that a company is sited in an extremely cyclical diligence and can’t afford to turn into overextended in the aspect of an unavoidable downturn in trades and revenues.
Methods to Reduce Gearing Ratio
In bookkeeping, the value of gearing ratio of a company can be reduced by the following methods:
- Trade shares. If an SME is able to take permission of the sale of shares from its board of directors, then the revenue received after selling shares could be utilized to pay loans.
- Convert debt. These debts could be converted into shares after negotiating with lenders.
- Decrease working capital. There are two ways to decrease the working capital: one is reduced levels of inventory and escalating the speed at which receivable accounts are collected. The second is to increase the duration in which accounts payable is required to pay and/or lengthen the days required to pay. By these methods, cash is produced which is used to pay off debts.
- Escalation of profits. Practice all known methods to increase revenues so that more cash is generated which could be used to pay off loans.
SMEs should maintain a low gearing ratio as it shows that the company is financially stable. This will result in attracting a large number of potential investors or lenders.
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