Quite often investors confuse between the Debt/Equity Ratio and the Gearing Ratio. In a sense they are related because the Gearing Ratio can be approximately seen as the inverse of the Debt/Equity Ratio. But there are 3 important points to apprehend here. Firstly, the Gearing Ratio looks at all fixed interest bearing liability and also includes preference capital as an external debt, not as equity. Secondly, Gearing Ratio is critical when it comes to evaluating the financial health of a company. Just as an automobile uses gears to enhance the power of the engine, gearing calculates how the company is using debt to get more value out of its capital. Thirdly, gearing gives us a model to assess the risk-return trade-off in the capital structure of a company. For example, equity does not have a fixed commitment but the cost of equity is higher as investors expect higher returns for the higher risk and cash flow uncertainty. On the other hand, debt reduces the capital cast but it adds to the solvency risk of the company. It is this capital compromise that can be studied using the Gearing Ratio.
Gearing ratio is used to evaluate and measure how efficiently the capital mix of a company is structured. It is measured by dividing the common stockholders’ equity by fixed interest or dividend bearing funds. Mathematically it can be presented as under…
Let us first understand specifically what is to be included in 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 and preference shares with fixed dividend payouts. It needs to be remembered that the Gearing Ratio is essentially a balance sheet ratio and all the requisite variables are available in the balance sheet of the company itself.
Let us quickly look at Gearing from an example point of view.
How do we calculate the Gearing ratio for both the fiscal years?
Gearing = (Share Capital + General Reserves) / (Preference Shares + Long Term Bonds)
Gearing for 2017-18 = (3.50 crore + 2.50 crore) / (1.40 crore + 1.70 crore)
= 6.00 crore / 3.10 crore… Therefore Gearing Ratio (2017-18) = 1.935 times
Gearing for 2018-19 = (2.80 crore + 2.85 crore) / (1.80 crore + 1.90 crore)
= 5.65 crore / 3.70 crore… Therefore Gearing Ratio (2018-19) = 1.527 times
In the above calculation, the gearing ratio of the company has actually worsened from 1.935 times to 1.527 times, adding a huge element of financial risk in the balance sheet of the company. The Gearing basically tells that the fixed interest bearing capital has grown at the cost of core equity capital. Why has the gearing worsened? Look at the four items in the capital structure. On the equity side the reserves are up due to higher profits during the year but the share capital is down due to a share buyback. On the other hand, the company had increased its level of preference shares and long term debt over the last year which has led to the worsening of the gearing ratio. Effectively, the company has tried to play the EPS game by doing the buyback which tends to partially hide the fact that the debt has gone up relatively. These finer aspects are captured by the Gearing Ratio.
While that is well understood on the financial risk front, how can an investor interpret shifts in the gearing ratio of a company? To interpret this ratio better one needs to look at the Interest Coverage ratio (ICR) or the Debt Service Coverage Ratio (DSCR) in conjunction with the Gearing Ratio.
Interest coverage = EBIT / Interest Cost
DSCR also captures the principal repayment component of debt during the year to give a more comprehensive picture.
Interest coverage essentially measures how much of the operating profit is available to service debt. Companies with low interest coverage are more at risk when they take on debt whereas companies with more comfortable interest coverage ratios are less at risk. In the above case, the gearing ratio is worsening over the last year. If this is happening with a flat or worsening interest coverage ratio, then it is a matter of worry for investors. It exposes the company to a huge financial risk and that leads to lower P/E valuations.
Gearing helps measure whether 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 coverage ratios. A worsening gearing ratio of a company is not a good sign. It is a sign of lack of discipline with respect to borrowings, something the markets are rarely comfortable with!
(By Jaikishan Parmar, Senior Equity and Research Analyst, Angel Broking)