The gearing ratio measures the proportion of funds borrowed by a company to equity. It calculates as the total loan (liabilities of the long and short-term included in this loan) divided by the total equity of the shareholder. Equity is a necessary term used in bookkeeping. A specific formula uses to calculate the 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 with a 10% gearing ratio would pay off debts more quickly. Investors also consider it a low-risk company, while companies with a high gearing ratio of around 50% or above are a greater risk because they could be defaulters or bankrupts if profits decline for short periods or rates of interest increase.
One way for you to evaluate the financial fitness of a company, the gearing ratio is one of the most common tools. The formula to calculate the gearing ratio in bookkeeping is as follows:
Gearing ratio formula = Debt / (Debt + Equity)
Types of gearing
- Financial gearing
- Operational gearing
Financial gearing
Financial gearing includes using debt to fund a business.
The risk is increased by financial gearing through returns. The debt is a risk for the business. It is a relationship between loan and equity, i.e., how a company funds itself.
Operational gearing
This term is less common. It is the relationship between fixed costs and variable costs of the business.
Disadvantages of higher gearing ratio
A higher gearing ratio suggests great leverage when an SME consumes 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 hazardous when a firm involves variable debt engagement interest rates because a sudden rise in rates could lead to severe problems in the payment schedule.
A regulated industry such as utilities is not as affected by this. They have a monopoly in business, and regulatory authorities will increase the rate to cover the gap and ensure their continued survival. Financiers’ possible requirements to lessen this problematic situation are restricting agreements that disallow the payment of shares, enforcing extra cash flow into debt repayment, constraints on substitute usages of cash, and conditions for shareholders to place additional equity into debt repayment firms. Creditors have a similar concern but are commonly incapable of enforcing alterations on the conduct of the firm.
SMEs which require significant fixed assets have a higher gearing ratio. A company with a low gearing ratio may be managing finances with a conservative approach. However, it may indicate that a company is sited in highly cyclical diligence and can’t afford to turn overextended in the aspect of an unavoidable downturn in trades and revenues.
Methods to reduce the gearing ratio
In bookkeeping, the value of the gearing ratio of a company can reduce by the following methods:
- Trade shares. If an SME can take permission to sell shares from its board of directors, it could utilize the revenue received after selling shares to pay loans.
- Convert debt. You could convert these debts into shares after negotiating with lenders.
- Decrease working capital. Two ways to decrease the working capital are reduced inventory levels and escalating the speed at which receivable accounts collect. The second is to increase the duration in which accounts payable requires paying and lengthen the days needed to pay. By these methods, cash is produced, which uses to pay off debts.
- Escalation of profits. Practice all known methods to increase revenues so that more cash generates, which could use to pay off loans.
Conclusion
SMEs should maintain a low gearing ratio as it shows that the company is financially stable. You will result in attracting many potential investors or lenders.
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