Gearing (or leverage) are among the most important factors in financial analysis. In financial management, using right leverage can help a business achieve their objectives. But if things are out of control, the punishment is so high that the business would possibly go bankrupt. To procurement professionals, a strategic supplier gone liquidated is no good news. It brings a serious risk to the supply side of the organisation. Therefore, sometimes it is the duty of procurement to analyse the financial situation of the supplier before it’s too late, especially gearing ratios.
Why is it named leverage/gearing?
The finance jargon “gearing” and “leverage” is inspired by the power of lever and gears in engineering. Levers and gears are tools for moving heavy objects which are normally hard (or impossible) to be moved. Leverage, therefore, is a financial tool that enables the business to achieve impossible outcome under normal circumstance.
For example, can you buy $5000 car when you only have $2000? It may seem unrealistic if the only source of finance you have is your personal saving. However, you can get your dream car if you take a loan from your relatives or from the banks.
The act of financing a project/a business/a purchase with both equity and debt is called gearing/leverage. Gearing ratios measure the proportion of debt and equity in a business.
There are several ways of measuring gearing. Each one has different purposes which we will identify below.
Debt to assets
The ratio of total debt to total assets measures the proportion of all assets financed by debt. It provides a balance sheet perspective on leverage.
Long-term Debt to Capitalization
This formula is more subtle than the above since it only considers long-term debt, instead of Total Debt. The denominator of the formula is called capitalization, or total capital that a business can use in long-term to finance its objectives. The formula removes current liabilities, which are parts of daily operation. This ratio tracks what proportion of a company’s financing comes from debt and therefore diverts attention from liabilities that are part of operations. This is a measure of long-term risk that a business may expose. Therefore, this formula is mentioned in L4M4 Study guide as a ratio for qualifying the supplier.
Assets to Shareholders’ Equity
Leverage provides the ability to control more assets than an owner would otherwise have the right to control. This ratio tells us precisely how many more assets an owner can control relative to their own equity capital. As a consequence, it also measures how returns are magnified through the use of leverage. This ratio is used in DuPont analysis.
- Desai, Mihir. How Finance Works . Harvard Business Review Press. 2019