Debt/Equity ratio versus gearing ratio
The Debt/Equity (D/E) ratio and the gearing ratio are critical when it comes to evaluating the financial health of a company. These ratios calculate how debt is used to get more value out of its capital. (D/E) ratio is purely a ratio of your total long-term debt to your equity. It is a very basic measure of the leverage of a company. Gearing ratio measures the impact of debt on the capital structure and also assesses the financial risk due to additional debt. Effectively, gearing ratio is the broad category and debt/equity is one of the measures of gearing of the company.
What is gearing ratio all about?
Gearing ratio measures the efficiency of the capital structure. Gearing divides the common stockholders’ equity by fixed interest and dividend-bearing funds (includes debt and preference shares). This can be presented as under…
Let us also look at the granular components of the numerator and the denominator. Common stockholders’ equity in the numerator will include share capital, share premium, general reserves, and participatory preference shares. The denominator will include long-term, fixed-cost bearing capital like long-term bonds, term loans, NCDs, and preference shares with fixed dividend payouts. Gearing ratio is basically a balance sheet ratio and therefore, all the necessary variables are available in the balance sheet of the company itself.
Understanding Gearing Ratio with a live example…
|Particulars||Fiscal Year 2016-17||Fiscal Year 2017-18|
|11% Preference Shares||2,80,00,000||3,60,00,000|
Gearing is best understood when it is looked at as a time series. Let us compare the performance of the two years.
Gearing = (Share Capital + General Reserves) / (Preference Shares + Long-Term Bonds)
Gearing for 2016-17 = (7cr + 5cr) + (2.8cr + 3.4cr)
= 12cr/6.2cr; thus, Gearing Ratio (2016-17) = 1.935x
Gearing for 2017-18 = (5.6cr + 5.7cr) + (3.6cr + 3.8cr)
= 11.30cr/7.4cr; thus, Gearing Ratio (2017-18) = 1.527x
Even a cursory glance is sufficient to underline that the gearing ratio of the company has actually deteriorated from 1.935x to 1.527x. What does this mean?
In the year 2017-18, the fixed commitment capital is much larger as a proportion of overall capital. That is because the company has increased debt and preference capital while it has reduced its share capital through a buyback. Despite the reserves going up due to higher profits, the overall gearing of the company has deteriorated. This adds a huge element of financial risk in the balance sheet of the company.
How can investors interpret gearing ratio?
There is a straightforward explanation for gearing. If gearing is falling yoy, then it means that the debt is increasing faster compared to equity. That is fine if your profits are also likely to increase at a rapid pace. If gearing is improving, it means the ratio of equity to debt is comfortable. But it runs the risk of the stock having a sub-optimal capital structure. It is balance that is the key. Ideally, to get the best interpretation of gearing ratio, it has to be looked at in conjunction with the interest coverage ratio. So what is the interest coverage?
Interest coverage = EBIT / Interest Cost
Interest coverage measures how much of your operating profit is available to service your debt. Companies with a low interest coverage ratio are more at risk when they take on more debt, whereas companies with more comfortable interest coverage ratios are less at risk from gearing. In the above case, the gearing ratio is worsening over the last year. If this is happening along with a deteriorating interest coverage ratio, then it is a worry for investors. It exposes the company to financial risk and that results in lower P/E valuations. You will normally find that companies that carry too much financial risk on their books tend to quote at low P/E ratios. That is a value trap and not a buy signal, so beware!
Gearing measures if the share of debt in the capital structure is sustainable or not. That can be decided only when it is looked at in conjunction with the coverage ratios. A worsening gearing ratio is never a good sign for any company. Markets have historically rewarded companies with more prudent debt management.