What is Financial gearing
Financial gearing, also known as financial leverage, is a metric used to assess a company’s financial risk by comparing its debt level relative to its equity. It indicates the proportion of a company’s funding that comes from debt rather than equity, helping investors and analysts understand how much risk the company is taking on to finance its operations.
A higher financial gearing ratio means that a larger portion of the company’s funding comes from debt, which can result in higher interest expenses and increased financial risk. This is because a company with a higher debt load may have more difficulty meeting its debt obligations during challenging economic times or periods of declining revenues.
On the other hand, a lower financial gearing ratio indicates that a company relies more on equity financing, which can be seen as a more stable source of funding since it does not require interest payments. However, relying too heavily on equity can dilute ownership and control for existing shareholders.
To calculate financial gearing, you can use the following formula:
Financial Gearing Ratio = Total Debt / (Total Debt + Total Equity)
Total Debt includes all interest-bearing liabilities, such as bonds, loans, and other forms of borrowing. Total Equity refers to the total value of shareholders’ equity, which is the residual interest in the assets of a company after deducting all its liabilities.
The financial gearing ratio is expressed as a decimal or a percentage, with a higher value indicating a higher level of debt relative to equity. It is important to note that an optimal financial gearing ratio varies by industry and individual company circumstances, and the interpretation of the ratio should be made in context.
Let us now look at an example.
Company X has 1 million $1 ordinary shares with a current market price of $3 each. It is also financed by $1million of 5% bonds with a current market value of 102.00 and $500,000 of bank loans. What is the company’s financial gearing?
Solution:
Financial gearing (also known as leverage) is a measure of a company’s financial risk, and it’s calculated by comparing the company’s debt to its equity. In this case, we need to calculate the total debt and total equity of Company X, and then find the financial gearing ratio.
- Calculate total equity: Company X has 1 million $1 ordinary shares, and their current market price is $3 each. So the total market value of the equity is: 1,000,000 shares * $3/share = $3,000,000
- Calculate total debt: Company X has $1 million of 5% bonds with a current market value of 102.00, and $500,000 of bank loans.
a) The market value of the bonds is 102% of the par value, which is $1 million. So, the market value of the bonds is: $1,000,000 * 1.02 = $1,020,000
b) The bank loans amount to $500,000.
So, the total debt is: $1,020,000 (bonds) + $500,000 (loans) = $1,520,000
- Calculate the financial gearing ratio: Financial gearing ratio = (Total Debt) / (Total Equity + Total Debt) Financial gearing ratio = $1,520,000 / ($3,000,000 + $1,520,000) = $1,520,000 / $4,520,000 ≈ 0.3363
The financial gearing ratio of Company X is approximately 0.3363 or 33.63%. This means that about 33.63% of the company’s capital structure is composed of debt, while the remaining 66.37% is equity.