The gearing ratio determines the proportion of funds borrowed by a business for owner’s equity or capital. Gearing is a measurement of a business’s financial leverage, and the gearing ratio is one of the well-known methods of describing a company’s financial health. It is a necessary term used in accounting books, and a particular formula is used to determine the gearing ratio for any business.
Low gearing would be the most appropriate option for SMEs when the amount of equity is required to pay the outstanding debts. A company with a 10% gearing ratio would be allowed to pay off debts more quickly, and investors will consider it a lower-risk company. Unfortunately, companies with a higher gearing ratio of 50% or above are at a greater risk because they can become defaulters or bankrupt when profits decline, or interest rates increase.
When evaluating a company’s financial health, it is common to use the gearing ratio tools.
The formula for determining the gearing ratio into accounts is as follows.
Gearing ratio= Debt/ Debt+ Equity
Types of Gearing:
There are two common types of gearing.
Financial gearing:
Financial gearing involves the utilization of debt in funding the business. The risk gets raised by the financial gearing, but returns are increased. It is the relation between debt and equity.
Operational gearing:
Operational gearing is used less commonly but has immense importance. It indicates the relationship between the variable and fixed costs of the business.
Advantages of Low gearing for SMEs:
You’ll always be the sole owner:
One significant advantage of a low gearing ratio is that you won’t give up business ownership. When you borrow a loan from an alternative lender or a financial institution, you must make the repayments promptly. On the contrary, if you give up on the equity in the form of stock in return for funding, you might not find yourself satisfied with getting input from external parties regarding the financial future of your small enterprise.
Lower interest rate:
With a low gearing ratio comes a lower interest rate. In case of a loan requirement, every business owner wants to borrow as low as possible, especially the SMEs. The reason is their new entrepreneurship and startup. They don’t get to indulge in the ocean of debt and higher interest rates along with the debt come. If your company doesn’t qualify for a banking loan, plenty of local creditors and lenders are available with whom you can connect about loans. Low gearing allows a lower interest rate because you don’t need to borrow such a huge amount in the first place.
Tax deduction:
A substantial advantage of the low gearing ratio is the tax deductions, classified as a business expense. The debt’s principal and interest rate will be deducted from your company’s income taxes. However, as an entrepreneur, you must consult a professional tax planner to answer questions about how the debt affects your taxes.
It helps to build business credit:
According to the survey, one of the primary reasons SMEs fail is a lack of working capital and funding. Stellar business credit is crucial if you’re looking for low-cost and long-term debt funding. Therefore, developing your business credit is a significant advantage to taking out a loan.
When you start building your small business’s credit, you try to lessen the need to depend on your credit or other higher business funding options. A lower gearing ratio can also help you build more cordial and favorable terms with the vendors.
Serves protection to the SMEs:
Often, SME owners rely on expensive debt, including cash advances, credit cards, or lines of credit, to lift their businesses off the ground. A significant advantage of the low gearing ratio is its ability to help us pay the high-cost debt. Diminishing your cost of capital increases business cash flow.
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