Financial gearing refers to the relative proportions of debt and equity that a company uses to support its operations. This information can be used to evaluate the risk of failure of a business. When there is a high proportion of debt to equity, a business is said to be highly geared.
The formula used for financial gearing is:
For example, ABC International is unable to sell any additional shares to investors at a reasonable price to fund its expansion, and so obtains a $10,000,000 short-term loan instead. The company currently has $2,000,000 of equity, so there is now a 5x ratio of debt to equity. The company would most definitely be considered highly geared.
A company that engages in financial gearing probably does so for one of the following reasons:
- The current owners do not want to dilute their ownership by issuing shares to any new investors, so debt is the only remaining alternative for raising funds.
- A company needs a large amount of cash right now, perhaps for an acquisition, and cannot raise sufficient cash from investors to meet its requirement.
- A company wants to increase its return on equity measurement, and can most easily do so by using new debt to buy back shares from investors.
- A company is suffering a cash shortfall from its operations, and needs additional cash to bolster its operations.
A major downside of financial gearing is that the cost of the debt could increase, due to changes in market rates. Or, a company is achieving an insufficient return on its use of the funds, and so cannot pay for the interest or the return of principal. In either case, excessive gearing presents a significant risk of bankruptcy. This is a particular problem during an industry downturn, when cash flows inevitably decline. Consequently, the use of financial gearing must be prudent, to allow for some use of additional funds while not putting a business in jeopardy.