Discover how the debt ratio affects your small business’s ability to secure financing and investments and manage debt.
Financing your business can feel a little like balancing spinning plates.
Imagine a circus performer performing at the peak of his abilities.
Whenever they concentrate intently on balancing a rotating plate, even for just a fraction of a second too long, they run the risk of another plate unceremoniously falling to the ground.
But if they spend the same amount of time balancing each rotating plate, they’ll be home and dry (and their trusty plates will thank them).
When you keep a close eye on your company’s debt and equity, you’re equally committed to keeping what’s called the gearing ratio intact, whether you’re aware of it or not.
In this article, we’ll explain what gearing is and what it’s used for, how gearing is calculated and interpreted, and how your company can reduce it — increasing your company’s stability, flexibility and financial health.
What is gearing and what is it used for?
Gearing measures a company’s financial leverage, that is, the portion of its business that is financed with borrowed money (debt financing) compared to the owner(s)’ investments or retained earnings (equity financing).
Gearing is a useful metric for lenders, investors and small business owners alike.
It provides insight into a company’s risk level and helps lenders assess a borrower’s ability to repay debt.
Gearing also helps investors decide whether to invest in a particular company (or not touch it with a 10-foot pole).
And small business owners can use it to analyze their cash flow and decide whether they need to reduce their borrowing.
How to calculate the gear ratio
There are several ways to determine your gear, but here are the three most commonly used methods.
1. Debt to equity ratio
The most popular formula is the debt to equity ratio. It indicates how much debt your company uses to finance the business rather than using its own money.
Take your company’s total debt — short-term debt plus long-term debt — and then divide it by equity.
If you prefer debt to equity ratio as a percentage, multiply it by 100.
The formula looks like this:
(Short-term debt + long-term debt) / Equity
2. Debt ratio
Another popular formula is the debt ratio, which measures the proportion of your company’s assets financed by debt.
Divide your company’s total debt by its total assets.
Again, if you want the debt ratio as a percentage, multiply it by 100.
Here is the equation:
Total Debts/Total Assets
3. Equity ratio
A third formula is the equity ratio, which indicates the proportion of your company’s equity that is financed by equity capital.
Divide your company’s total equity by its total assets.
For an equity ratio expressed as a percentage, multiply by 100.
This is the calculation:
Total equity / total assets
Regardless of the debt formula you use, it will give you a good idea of how well your company can meet its financial obligations during economic fluctuations.
How should the gear ratio be interpreted?
A high debt-to-equity ratio (above 0.5 or 50%) means that your company has high financial leverage and therefore relies heavily on debt to pay for day-to-day operations, which is risky business in every sense of the word.
During an economic downturn, your business could have difficulty meeting its debt repayment plan, which could in turn put it at risk of default and even bankruptcy.
But not all companies with high debt are the same.
For example, a company with high levels of debt that operates in a capital-intensive sector such as automobiles or in a regulated sector such as utilities is not necessarily in poor financial condition, as high levels of debt are typical in these industries.
Likewise, companies with low debt levels do not have equal rights.
Although a low debt-to-equity ratio (below 0.25 or 25%) suggests that a company is using more equity than debt to finance the business, it can also mean that the company cannot use debt financing to expand.
The ideal debt ratio is between 0.25 (25%) and 0.50 (50%), which indicates a healthy balance between equity and debt financing.
To get a more complete picture of your company’s financial health, it’s important to put gearing in context.
In other words, your company’s metrics should be compared to other companies’ metrics in the same industry.
How to Use Gear Ratio: An Example
Let’s look at how your small business can benefit from calculating its debt-to-equity ratio.
For purposes of this illustration, we will call your fledgling accounting practice A‑Star Accounting (ASA).
Rumor has it that accountants are flocking to ASA, so they’re determined to open a second location.
However, you will need more funds to hire staff, purchase equipment and rent additional office space.
You can either apply for debt financing, such as a bank loan, equity financing (investment), or both.
By calculating ASA’s debt-to-equity ratio, you assess the financial risk associated with securing additional debt.
If the score is high (above 0.5), indicating a strong dependence on debt, you should reconsider applying for a bank loan and consider the equity route instead.
However, if the debt-to-equity ratio is, for example, below 0.25, this suggests that ASA is less reliant on debt to finance the business, making taking on additional debt significantly less risky.
How to reduce the gear ratio
Larry Hartman, Chief Strategic Officer at PixelFree Studioa software solutions company, shares his first-hand experience in reducing his company’s leverage.
“During PixelFree’s growth phase, we focused on equity financing to keep our debt in a safe range,” he says.
“Exploring equity financing options, such as attracting investors, can improve your balance sheet without increasing your debt.
“It definitely helped us grow without taking on too much debt, which is important for long-term success because it kept our finances stable.”
Larry recommends that companies reinvest profits into the business rather than borrowing more.
“To do this, reduce unnecessary costs and, to make more money, focus on providing high-margin goods or services,” he says.
Other ways to reduce your gearing include:
- Paying off long-term debt to reduce interest payments.
- Refinancing debt to benefit from lower interest rates or longer repayment terms.
- Selling non-essential assets to increase cash reserves and pay off more debt.
Final thoughts
Gearing is a small metric that goes a long way in informing lenders and investors about your company’s financial health.
It is also a great boon for your business analysis.
By keeping a close eye on your debt, you’ll not only be better positioned to weather any financial storms that come your way, but you’ll also be better informed if your business attracts interest from investors.
