You flip through the annual report and the CEO writes about increasing the company’s gearing ratio. You ask yourself: “What is this gearing ratio?”
Gearing ratio measures the degree of leverage in a company. The higher the gearing ratio, the more debt a company takes on to run its business. A quick way to calculate a firm’s gearing ratio is using the formula below:
Gearing Ratio = Total borrowings / Total Shareholder’s Equity
Many companies tend to adjust their gearing ratio with their cash position which gives the net gearing ratio.
Net Gearing Ratio = (Total borrowings – cash and cash equivalents) / Total Shareholder’s Equity
An excerpt from Hyflux Ltd (SGD:600)’s 2013 annual report can be used to calculate the net gearing ratio as shown below:
|Cash and cash equivalents
|Short-term loans and borrowings
|Long-term loans and borrowings
|Total equity attributable to owners of the Company
|Net Gearing Ratio
Based on the calculation made, Hyfux Ltd increased its net gearing ratio from 0.574x to 1.16x during 2012 to 2013. The deterioration in leverage was due to an increase in bond issues to fund its desalination projects overseas. If we look at other companies, it is critical to understand why the company has decided to pile on more debt. Does the company’s capital structure allow more debt to be taken on? Are there future expansions requiring large capital outlay and working capital? It is a good idea to read management’s letters to shareholders as it gives clues to how a company is expected to develop its business going forward and how it intends to fund its operation. Understand the reasons and implications behind management’s decision to take on more borrowings. If its capital structure allows, piling on more debt may not necessarily be a bad thing since its cost of debt is usually cheaper than issuing more shares.
A company with a high gearing ratio is more susceptible to economic downturns as the company must continue to service its debt obligations regardless of a decline in the firm’s profits. A larger proportion of equity versus a company’s total borrowings provide a higher buffer and is seen as a measure of financial strength.
Value in Action
The gearing ratio measures the degree of leverage in a company. The higher the gearing ratio, the more debt a company is using to run its operations. It is important to understand the reason why a company would take on more debt. Sometimes, it could be beneficial to equity holders.
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The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie doesn’t own shares in any companies mentioned above.