Financial Gearing can be defined as a financial figure that is actually a relative proportion of debt and equity that is used by the business for performing its operations. If the high ratio of debt to the equity id calculated a business is said to be in a high gearing.
Formula of Financial Gearing
The formula of Financial gearing can be shown as under:-
Financial Gearing = Short Term Debt + Long Term Debt + Capital Leases/ Equity
Example of Financial Gearing
The example of financial gearing can be presented as of a company say ABC is unable to attract inventors for additional expansions of its business as there no investor interested to buy their shares. In order to expand its operations the company obtains a loan of $10,000,000 that is a short term loan. The current equity of the company is $2,000,000 that is 5X of the loan taken by the company. This ratio shows that the company is highly geared.
Importance of Financial Gearing
There are several reasons due to which a company may involve in high financial gearing such as a company doesn’t want to raise investment by issuing shares to the investors and diluting their ownership in the company and they used loan option for the expansion of the company. Another reason of gaining high financial gearing is that a company requires a high amount of cash for acquisition or some other reason and don’t have proper investors to invest in the company. Sometimes a company wants to increase earnings per share or wants to increase its ownership in the company and this can be done by buying shares back from the investors that may result in greater financial leverage.
Financial leverage has a number of short comes and the most prominent is that the cost of debt of the company will increase.