Saturday, 22 June 2013

Gearing Ratios

Gearing is a measure of a company's leverage. The higher the leverage of a company, the more risky it is.

A company basically made up of 3 components, as stated in its balance sheet:

1. Assets (what the company own)
2. Liabilities (what the company owe to others)
3. Equity (investment by shareholders/owners)

To start a new company, we need to have initial investment from shareholders (equity). The company will then use the equity fund to buy assets and run its business. To support and grow the company, most of the time it will need to get loans (liabilities).

In a balance sheet, all 3 components must be balanced:

Assets = Equity + Liabilities

This means that a company can get fund/money by 2 ways:

1. From shareholders or owners (equity)
2. From creditors (liabilities)

The fund acquired through shareholders & creditors are kept in the company as assets. Thus, assets = equity + liabilities.

There are two types of liabilities:
- operational (payables): owed to business partners
- debt (borrowings): owed to banks/creditors

We can measure the degree of a company's leverage with gearing ratios. Basically these ratios tell us how much the business activity is funded by shareholders fund vs creditors fund.

Debt Ratio = Total Liabilities / Total Assets
- a quick measure of a company's leverage, the lower (<1.0) the better

Debt to Equity Ratio = Total Liabilities / Shareholders Equity
- indicates the proportion of equity & debt the company is using to finance its assets
- creditors vs shareholders - who owns the company more?
- the lower (<1.0) the better

Debt to Capital Ratio = Debt / Shareholder Equity + Debt
- indicates debt-financing vs equity financing

Current Ratio = Current Assets / Current Liabilities
- Current Assets: Cash & cash equivalent, inventories, receivables
  Current Liabilities: Current debt, payables
- the higher (>1.0) the better, indicates whether the company is able to pay its debts in short term (<12 months)

Interest Coverage Ratio = EBIT / Interest Expense
- measures ability to pay interest expenses of outstanding debt (better >1.5)

Cash Flow To Debt Ratio = Operating Cash Flow / Total Debt (borrowings)
- measures ability to cover total debt with yearly cash flow from operation

There is no "standard" value for the ratios above, as it is different between various industries. Generally, if the debt/liabilities is the numerator, the lower the ratio the better it is. If the assets/earning is the numerator, the higher the ratio the better.

The above formulas are text book formulas. However, I notice that for debt to equity ratio which is widely used by analysts, NET borrowing is used instead of total liabilities.

This means the numerator is total borrowings (not including payables) minus cash & equivalents. 

Anyway, I think that no matter which formula you use, just choose only one and use it for comparison purpose.

No comments:

Post a Comment