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# Understanding the Importance of Gearing Ratio

The gearing ratio is a critical ratio when it comes to evaluating the financial health of a company. Like an automobile gear is used to get more power out of your car, the gearing ratio calculates how the company in question is using debt to get more value out of its capital. All capital structures are a trade-off between debt and equity. Debt as a source of capital has a lower cost as it offers a tax shield on the interest paid. But on the other side, debt also creates committed liabilities in your books and it also is a key source of financial risk or solvency risk as we call it. Gearing ratio measures this impact of debt on your capital structure and also makes an attempt to assess the financial risk that is imputed by the additional debt.

So what exactly is the importance of the gearing ratio to investors and how should it be interpreted? What is the gearing ratio formula used to calculate the gearing of a company and decide upon its debt / equity mix. Lastly, how is the gearing ratio evaluation done and how is the gearing ratio interpreted?

What is gearing ratio all about?
Gearing ratio is used to evaluate the efficiency of the capital structure of the company. It is calculated by dividing the common stockholdersâ€™ equity by fixed interest or dividend bearing funds. Mathematically it can be presented as under..

Here we need to understand specifically what is to be included in the numerator and the denominator. Common Stockholdersâ€™ equity in the numerator will include share capital, share premium, general reserves and participatory preference shares. The denominator will include long term fixed cost bearing capital like long term bonds, term loans and preference shares with fixed dividend payouts. It needs to be remembered that the Gearing Ratio is essentially a balance sheet ratio and all the requisite variables are available in the balance sheet of the company itself.

Understanding Gearing Ratio with a live example..

ParticularsFiscal Year 2015-16Fiscal Year 2016-17Share Capital3,50,00,0002,80,00,000General Reserves2,50,00,0002,85,00,00011% Preference Shares1,40,00,0001,80,00,000Long Term Bonds1,70,00,0001,90,00,000

We can now calculate the gearing ratio for both the years using the below mentioned formula..

Gearing = (Share Capital + General Reserves) / (Preference Shares + Long Term Bonds)
Gearing for 2015-16 = (3.50 crore + 2.50 crore) + (1.40 crore + 1.70 crore)
= 6.00 crore / 3.10 croreâ€¦ Therefore Gearing Ratio (2015-16) = 1.935 times
Gearing for 2016-17 = (2.80 crore + 2.85 crore) + (1.80 crore + 1.90 crore)

= 5.65 crore / 3.70 croreâ€¦ Therefore Gearing Ratio (2016-17) = 1.527 times

As can be seen from the above illustration, the gearing ratio of the company has actually worsened from 1.935 times to 1.527 times adding a huge element of financial risk in the balance sheet of the company. Why has the gearing worsened? Let us look at the four items in the capital structure. On the equity side the reserves are up due to higher profits during the year but the share capital is down due to a share buyback during the year. On the other hand, the company had increased its level of preference shares and long term debt over the last year which has led to the worsening of the gearing ratio.

What is the significance of the Gearing Ratio for an investor?

While that is well understood on the financial risk front, how can an investor interpret shifts in the gearing ratio of a company? To interpret this ratio better one needs to look at the Interest Coverage ratio in conjunction with the Gearing Ratio. What do we understand by the Interest coverage ratio?

Interest coverage = EBIT / Interest Cost

Interest coverage measures how much of your operating profit is available to service your debt. Companies with low interest coverage ratio are more at risk when they take on more debt whereas companies with more comfortable interest coverage ratios are less at risk from gearing. In the above case the gearing ratio is worsening over the last year. If this is happening with a flat or worsening interest coverage ratio then it is a matter of worry for the investors. It basically exposes the company to a huge financial risk and that normally leads to lower P/E valuations.

The bottom-line that Gearing helps us to find whether the share of debt in the capital structure is sustainable or not. That can only be decided only when it is looked at in conjunction with the coverage ratios. Even otherwise, a worsening gearing ratio of a company is not a good sign. It is basically a sign of lack of discipline with respect to borrowings, something the markets are not comfortable with!

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