Financial gearing in accounting

Financial gearing measures the proportion of debt compared to equity. It’s a tool for determining whether business operations are financed by debt or equity. So, if a large proportion of the business finance comes via debt, the business is considered financially geared, and vice versa.

It’s important to note that higher financial gearing drives higher business risk and vice versa. Let’s explore why higher financial gearing is considered risky in detail.

Why higher financial gearing is considered risky?

Higher credit risk—Debt is a riskier source of financing. A higher proportion of debt in the financing structure reflects higher credit risk, resulting in higher business risk.

Reduced profitability– The loan comes with interest cost. This expense needs to be paid as a priority to avoid reputational and financial repercussions. Hence, profitability is compromised when financial gearing is higher.    

Less attractive for equity investors—Companies with higher financial gearing become less attractive for equity investors. The reason is that interest on the loan has to be paid first, and creditors stand first in case of liquidation.

The formula for financial fearing

Financial gearing = Debt/Equity

Higher financial gearing is associated with higher risk and vice versa. So, why do companies often prefer to raise finance via debt?

The reason is that debt is a cheaper source of finance than equity. Interest paid on loans is tax deductible and is less risky than equity investment. Hence, debt is a cheaper source, and companies often opt to raise finance via debt.  

Example calculating financial gearing

ABC Co’s financing structure shows debt amounting to $25,000 and equity amounting to $50,000. The financial gearing can be calculated as follows.

Financial gearing = Debt/Equity

= $25,000/$50,000

= 50%

Is financial gearing the same as operational gearing?

Financial gearing is about measuring the proportion of debt to equity, but operational gearing refers to measuring the proportion of fixed cost compared to total cost.

So, financial gearing is about debt, and operational gearing is about cost structure of the business.

Conclusion

Financial gearing measures the proportion of debt in relation to equity. In other words, this measure compares the proportion of debt with the equity. So, if debt financing is higher than equity, it suggests higher financial gearing and vice versa.

Higher financial gearing is considered highly risky because a higher proportion of debt financing suggests higher credit risk, reduced profitability, and less attractiveness to equity investors.