The Determinants Of A Firms Gearing Ratio

Gearing ratio refer to a proportionate of debt to equity that being employed by companies as source of financing of their companies. It is also known as capital structure. Composition of debt to equity is said to effect the companies performance. Thus, this paper try to examine the determinants of gearing ratiovof firms. The study is based on secondary data through a library resesarch of several studies and rticles related to determinants of capital structure.

This paper is divided into sections. The first section discuss briefly on gearing ratio. It includes definition of gearing and several methods used in calculating gearing ratio by different researchers. The second section explain the variables that will influence the gearing ratio. There were several studies done to identify determinants of capital structure of a firm and effect the gearing level. These variables were identified throught various research carried out by previous researchers. Then only this paper will summarise on the effect of gearing towards firms’ performance from findings of relevant study carried out on the relationship between gearing and firms’ performance. The last section will be the conclusion and limitation of this study.

Gearing

Capital structure is the composition in the firm capital financing in order to finance their assets. Capital structure can be a combination of both equity and liabilities (Karadeniz, Kandir, Balcilar, and Onal, 2009; Bokpin, 2009; Kyereboah-Coleman, 2007). Firm may select to be a high geared or low geared firm depending on their level of debt employed for their capital financing (Abor, 2007).

Equity capital is considered as internal financing and can be in a form of share capital. Shere capital is financing generated from the issuance of shares for cash or other consideration. It is not static for the whole year but changes depend on the issuance made by firms. Share capital comprise of both commom and preferred shares. It also known as equity financinag. Dividend paid to shareholders is cost to the firm when issues equity financing. Retained earnings is part of equity financing as well.

Debt is defined as any interest-bearing liability. Interest expenses is cost of issuing debt capital. Debt is further classified as long-term debt and short-term debt. long-term debt is debt due for more than a year whereas short-term debt is debt due within a year. Long-term debt can be in the form of bank loan, debentures, bond and long-term notes payable. Bank overdraft is an example of short-term debt. long-term debt is used most of the time to finaced non-current assets whereas short-term debt is used to financed the firm’s working capital requirement.

Gearing ratio is the proportion of debt to equity of the firm. It is calculated by dividing the total debt to total equity of the firm. It can further divided into two; total short-term debt divided by total equity and long-term debt divided by total equity. The firm with more than 50% debt-to-equity ratio is considered as high geared firm while firm with debt-to-equity ratio less than 50% is a low geared firm.

Determinants of Gearing

Size

There were studies carried out to examine whether size of firm will affect the gearing level of firm (Karadeniz, Kandir, Balcilar and Onal, 2009; Seppa, 2008; Biger, Nguyen and Hoang, 2008; Al-Najjar and Taylor, 2008; Abor, 2007; Eriotis, 2007; Jandik and Makhija, 2001). There were various method of determining the size of firm. Some might value firm as large or small using the logarithm of total sales (Seppa, 2008; Karadeniz et al., 2009; Biger et al., 2008; Eriotis, 2007; Jandik and Makhija, 2001). Sales is used to measure size of firms because it will eliminates likely booking problems related to business assets (Seppa, 2008; Abor, 2007). Al-Najjar and Taylor, (2008) in his study however has use logarithm of total assets in classifying between large and small firm.

Size of firm is associated with risk and bankruptcy cost. The larger the firm the less risky and probability of bankruptcy due to it is more diversified as compared to smaller firms (Al-Najjar and Taylor, 2008; Eriotis, 2007). Thus, it is less likely that larger firm will default in their liability settlement. Thus, size is predicted to be positively related to gearing (Bhabra, Liu, and Tirtirogiu 2008; Eriotis, 2007; Jandik and Makhija, 2001). In addition to that, larger firm usually borrowed large sum of money than smaller firm. This in turn can reduce the transaction cost, thus reduce interest rate. Lower interest cost and transaction cost will influence firms to take more debt (Owusu and Badu, 2009; Eriotis, 2007).

There were empirical evidence that size of the firmss have positive influence towards the firm’s gearing ratio (Seppa, 2008; Biger et al., 2008; Al-Najjar and Taylor, 2008; Abor, 2007; Jandik and Makhija, 2001). Al-Najjar and Taylor, (2008) in his study found out that large firms in Jordan were well diversified as compared to those small firms. Thus, it reduces the possibility to be financially distress and reduce bankrupcy cost (Seppa, 2008; Al-Najjar and Taylor, 2008). This will lead to higher debt can be obtained and increase gearing. This result was supported also by Eriotis (2007); Jandik and Makhija, (2001). Opposite to the previous result, Karadeniz et al., 2009 in his study shows that there is insignificant effect of size towards the firm’s gearing ratio. The study examine the detrminants of capital structure for Turkish lodging firms. Abor (2007) support the positive realation between size and gearing by the large value of assets held by larger firms that can act as collateral.

Financial policies

Owusu and Badu, (2009) Financial policies is another factors affecting capital structure choice. A study done in Ghana by Owusu and Badu (2009) shown that financing policies and source of finance can influence the capital structure choice among the contractors. It depends on the availability and flexibility of the facility. The composition between debt and equity capital depend on whether there is availability of such funding. If the firm wants to increase its debt capital but there is no willing party to lend the money, thus the firms will be unable to further increase its debt.

Flexibility refer to the level leverage of the firm. Whether it is too levered or still considered as low geared. Most of debt financing especially long term debt would require collateral. Thus, flexibility include the availbility of assets to be pledge as collateral. Although the firm is high geared, increase in its debt capital would be considered by the lender if they have assets for collateral. Flexibility takes into account the reasonable cost of capital, maturity period, prepayment provisions, conditions of contract and amount of collateral required (Owusu and Badu, 2009). If debt capital is no longer available, then only firm will use equity capital.

Assets structure

Assets structure refers to firms’ total assets composition of non current assets and current assets. Several researchers try to examine the relationship between tangibility of the assets with level of gearing (Owusu and Badu, 2009; Karadeniz et al., 2009; Biger et al., 2008; Al-Najjar and Taylor, 2008; Abor, 2007). Tangibility means the availability of tangible non current assets to be pledge as collateral for the purpose of borrowing. To measure the tangibility of a firm, most researchers use total fixed assets over total assets (Owusu and Badu, 2009; Karadeniz et al., 2009; Biger et al., 2008; Al-Najjar and Taylor, 2008; Abor, 2007). The higher the fixed assets of firms represent high tangibility.

Some findings from literature shows a positive relationship between tangibility and gearing (Owusu and Badu, 2009; Al-Najjar and Taylor, 2008; Bhabra et al. 2008; Abor, 2007). The higher the fixed assets value the higher the gearing. This is satisfy the reason that fixed assets can act as collateral to the borrowing. Abor (2007) in his study also found out that firms with high current assets tend to employ more short-term debt as compared to long-term debt.

However, there are still findings that show negative relationship between tangibility and gearing. Results from the findings shows that level gearing is decreases as fixed assets increase (Karadeniz et al., 2009; Biger et al., 2008). According to study done by Karadeniz et al., 2009 in the Turkish lodging firms, high fixed assets value does not reflect high gearing ratio. Most of firms in Turkish tend to use short-term debt more than long-term debt. This is due to lack of availbility of long-term debt financing in Turkey as a result of political and economic unstability as well as under-developed capital market. In Vietnam, lending institution prefer to grant loan to firms with high current assets as compared to firms with high fixed assets explained why tangibility and gearing have negative relationship. This is due to lending institution will value the liquidity position of a firms before grant loan. Since current assets is more liquid than the fixed assets, thus lead to hihger gearing to firms with higher current assets value (Biger et al., 2008).

Growth rate/growth opportunities

Growth opportunities can be describe as increase in market value of firm’s assets that will add firm’s value but can not act act collaterals (Biger et al., 2008). It examine whether firm’s with higher growth rate will have higher gearing or otherwise. There were some researchers did study the relationship between firm’s growth rate with gearing (Karadeniz et al., 2009; Biger et al., 2008; Al-Najjar and Taylor, 2008; Eriotis, 2007; Jandik and Makhija, 2001). Growth rate is usually measure using market-to-book ratio (Karadeniz et al., 2009; Al-Najjar and Taylor, 2008; Jandik and Makhija, 2001). It also can be measure using percentage change in the total assets of the firms (Biger et al., 2008). Annual change in earnings can in addition used to measure growth (Eriotis, 2007).

High growth firms will be more likely to have greater agency problems due to a more flexiblity in their investment choices, thus should lead to a negative relationship with gearing (Al-Najjar and Taylor, 2008; Bhabra et al. 2008). Jandik and Makhija, (2001) support the view when findings from his study found out that electric and gas utilities industries has a negative relationship between growth rate and gearing. Furthermore, Eriotis (2007) in its finding reveal the same result as previous study by Jandik and Makhija, (2001). The argument behind that is growth is measure using annual change in earnings. Thus high growth firms reflect higher volitility in their earnings which represent as high risk firm. Thus, it is difficult for high risk firm to obtain loan.

Some other findings demonstrate a positive relationship between growth rate and gearing (Biger et al., 2008; Al-Najjar and Taylor, 2008). These studies reveal that high growth Jordanian and Vietnamese firms favour towards debt financing for their investment opportunities. This is also might be due to little likelihood of bankruptcy that encourage financial institution to grant more loan towards high growth firms.

Despite of the above results, Karadeniz et al., (2009) found out that there is insignificant relationship between growth and gearing. It shows that growth opportunities do not have significant influence towards gearing in the Turkish lodging firms.

Ownership Structure

Ownership structure of a firm may influence the firm’s gearing. This is due to different ownership will have different style of management. Ownership structure refer to composition of the owner of firms. Owner of a firm can be from an institutional or an individual (Biger et al., 2008; Al-Najjar and Taylor, 2008). It can also be categorize as foreign owned or locally owned firm (Biger et al., 2008). Further issue on ownership structure is on a large shareholders (Zuoping, 2010).

Institutional ownership.

Institution refer to any influence by political, social, and legal rules in managing the firm’s resources and activity. It is evidence that fully state-owned shows a lower gearing as compared to partly state-owned firms (Zuoping, 2010; Biger et al., 2008; Al-Najjar and Taylor, 2008). It shows that fully state-owned firms prefer to use equity financing. However, in China, there is evidende that state owned firm positively related with high gearing (Bhabra et al. 2008).

In 2008, Bhabra et al. and Al-Najjar and Taylor in their articles have examine whether there is significant different in gearing of fully state-owned firms and fully foreign owned firms. The finding shows that fully foreign-owned firms have lower gearing since major source of financing come from their parent company.

Further, Zuoping (2010) examine whetehr legal environment will have an effect towards gearing of a firm. He state that legal environment is important as a control mechanism to prevent illegal action of the management. It is hypothesise that a good legal environment will have positive relationship with gearing and the result support the hypothesis.

Large of shareholders.

Shareholders of a firm may effect firm’s gearing ratio. Zuoping (2010) has examinecertain issues whether shareholders with large number of shares will effect firm’s gearing or not. First, he try to examine the relationship between controlling shareholder who owned the largest proportion of shares and firm’s gearing. Result show a negative relationship between them. It means that, the larger the proportion of shares held by controlling shareholder, the lower the debt. It prefer equity capital since debt capital will increse the unlikely of a firm may not be able to pay dividends as a result of higher interest expenses.

Further he examine whether a proportion of shares being held by a number of large shareholders except the controlling shareholder will effect the gearing ratio or not. There is evidencethe that high concentration of shares held by few number of large shareholders have a positive effect. This is due to higher concentration reflect a better governance.

Financial position or strength

It refers to the financial condition of a firm. It show whether the firm is financially health or not. Financial position is assessed using free cash flows (Owusu and Badu, 2009; Karadeniz et al., 2009). Free cash flows is arriving by adding back the interest expenses, depreciation and amortisation to earnings before tax or known as EBITDA (Karadeniz et al., 2009). Firm with high free cash flow considered as financially health or is said to have financial strength. It means that the firm able to finance its debt and liability in the long run using cash generated over a period of time (Owusu and Badu, 2009). Thus, financial position have a positive relationship with gearing. The higher the financial position, the higher the debt capital (Owusu and Badu, 2009; Upneja and Dalbor, 2001). The positive relationship between financial position can also be explained by financially health firm is a high growth firm thus it requires more debt to finance for its expansion (Upneja and Dalbor, 2001). Although financial position is said to have positive relationship, Karadeniz et al., (2009) found out that there is insignificant effect between them in the Turkish lodging firms.

Financial and business risk

Business risk is risk associated with the business activity. For example high volitile income firm is said to have a high business risk since the revenue is uncertain. Revenue consistency is important in decididng the source of financing thus it will effect the gearing of a firm. It is due to debt financing will incur fixed interest expense unlike equity financing that only declare and pay dividend based on their performance. Thus, consistency in revenue generation is important to ensure that a firm will be able to pay their interest when it fall due. Inconsistency or variability of revenue is measure through standard deviation of percentage change in operating income (Owusu and Badu, 2009).

Business risk is predicted to be negatively related to gearing because hihger business risk will lead to higher possibility of the firm not be able to repay its interest. This is supported by Al-Najjar and Taylor, (2008) in his study. Jandik and Makhija, (2001) has reveal an opposite result in his findings. There is evidence that the more variability of income the higher the gearing of the firm. However, there is no reason being explained by the author for the inverse relationship.

Diversification can help firm to avoid business risk. High diversified firm will be less likely facing a sudden shortfall in revenues. This is due to the revenues come from variety of sources. Thus, diversification should have a positive relationship with gearing. However, Jandik and Makhija, (2001) in his research reveal a negative association between diversification and gearing. He further add that diversified firm may have higher agency problems. Thus, there is tendency of mismanagement.

Liquidity

Firm’s liquidity is assessed using two types of ratio; current ratio and quick ratio. It measure the firm’s ability to meet its short term obligation. Thus, high liquidity ratio is a good signal in the sense that the firm’s current assets is sufficient to cover the firm’s short term obligation (Al-Najjar and Taylor, 2008; Eriotis, 2007). In addition, high liquidity also can be negative signal for the firm. It may shows that firm has spent so much on its current assets thus may end up loosing the opportunity for long term investment (Al-Najjar and Taylor, 2008).

Eriotis (2007) in his finding shows that liquidity is negatively related to gearing. The reason is that, comapnies with high gearing have high current assets that can help them generate future cash flows. Thus, it can be use to finance their activities rather than debt financing. Al-Najjar and Taylor, (2008) in its finding shows positive result between two variables. The higher the liquidity, the higher the gearing. It is because it has good reputation interm of the ability to settle the loan when it falls due.

Industry

There is study carried out to examine whether industry type would have a significant influence towrads gearing or not (Biger et al., 2008; Abor, 2007). Biger et al., (2008) did research in Vietnam. In this study, it classify the industry into two types; firms with simple product and do not require specialized services and firms that produces machinery and equipment. This study suggest that firms produces machinery should have less debt and it is supported by results of the study. The reason behind is, that kind of product is illiquid as compared to the other products. Further reason is, in Vietnam, loan is granted based on its liquidation capacity thus lead to difficulties for firms involve in producing machinery and equipment to get loan. This result is supported by astudy done in Ghana that reveal the construction and mining industry to potray the lowest gearing among other industries in Ghana (Abor, 2007).

In addition, Abor (2007) in his research done in Ghana reveal that agriculture industry have the highest gearing ratio and employ more long-term debt. This is due agriculture is considered as the industry for the country’s economic growth. Thus, this industry get more support from the government for their long-term debt. Wholesalers and retailers prove to have lower long-term debt as compared to agriculture. However, it still in the category of highest gearing. The result prove that both wholesellers and retailers to employ more short-term debt that make its gearing higher. It is because, they always make a credit purchase with their suppliers. The hotel and hospitality industry were found to have the lowest gearing. This result is supported by the small size of hotel and hospitality industry in Ghana.

Transaction cost

Transaction cost is cost involve whether in issuing equity capital or debt capital. Owusu and Badu (2009) in their study done suggest that transaction cost has an effect towards choice of equty or debt capital. If the cost of issuing debt is higher, thus firms will prefer towards equity capital. Transaction can be in the form of brokerage fees, issue cost and agency cost.

Dividend policy

Dividend policy can be a signal towards various stakeholders of the firms. If the firm has a good dividend policy, its will increase confidence of the stakeholders towards the firm including potential investors and debt provider. Thus, it will influence the firm’s choice of financing. Stakeholders will access the strength of a firm through the constant payment of dividend. It suggest that the firm that constantly declare and pay its dividend is a financially health firm. Dividend payout ratio can be use to analyse the dividend policy of the firm (Al-Najjar and Taylor, 2008). In relation to that, Al-Najjar and Taylor, (2008) in his finding show insignificant relationship between dividend policy and gearing.

Macro-economic indicators

Interest rate, taxation treatment and inflation rate form the component of macro-economic indicators in determining the firm’s capital structure (Owusu and Badu, 2009). These three factors are external uncontrollable factors by the firm. These factors usually under the goverment control. However, the changes in these three factors by government may lead to cahnges in gearing level of the firm.

Interest expenses is an expenses directly associated with the value of debts. Thus increase in interest rate might influence the firms’ gearing level. Increase in interest rate means higher expenses incurred for debt capital thus it will reduce level of gearing. Interest rate has a positive relationship with gearing (Owusu and Badu, 2009).

Tax rate is another important determinant of firms’ gearing choices. It is due to interest expenses is a deductible expenses in arriving at taxable income. Thus, the higher the interest expense the lower the taxable income. It is predicted a positive relationship between tax rate and gearing level (Owusu and Badu, 2009; Buettner, Overesch, Schreiber and Wamser, 2009). This is because, comapanies tend to employ higher debt at the higer tax rate to enjoy more tax deductible expenses and results in paying less tax. Several studies has examine the relationship between tax rate and gearing (Owusu and Badu, 2009; Karadeniz et al., 2009; Buettner et al., 2009; Biger et al., 2008).

Biger et al., (2008) and Al-Najjar and Taylor, (2008) in their findings reveal a negative relationship between tax rate and gearing. This is might be due to higher tax rate lead to lower net profit. It is difficult for firms with low profit to obtain more loan. This finding is applicable to Vietnamese firms and Turkish lodging firms.

Owusu and Badu (2009) in their study stated inflation as other factor that may effect gearing decision of firms. Inflation may encourage and discourage demand and supply of loan. In time with high inflation, loan provider will less likely to offer loan due to reduce in real value of money. High interest rate is required to compensate the reducing in real value of money. Thus, inflation may give some effect to the gearing ratio but there is no empirical result testing the hypothesis done by author. The study only do a survey questionaires to person in construction firms. Researchers do not further investigate the effect of inflation towards gearing.

Non-debt tax shield

Non-debt tax shield refer to ability of firms to have lower taxable income by having variety sources of choices to reduce such income (Jandik and Makhija, 2001). In this case, firm will less dependent on interest expenses (deductible expenses for tax purposes) in order to arrive at lower taxable income. Thus, it will lead lo low gearing. There are several measures used by researchers in determining the level of non-debt tax shiled of a firm. It can be measure by depreciation divided by total assets (Karadeniz et al., 2009; Jandik and Makhija, 2001). Jandik and Makhija, (2001) used investment tax credit over total assets since investment tax credit is applicale its period of study.

Based on the above statement, non-debt tax shield should have a negative relationship with gearing. It is supported by Jandik and Makhija, (2001) in his study. Karadeniz et al., (2009) in its finding reveal that there is insignificant relationship between non-debt tax shield and gearing.

Conclusion

Capital structure choice is important for a firm to ensure the performance of the firm. If firm take too much debt, it may lead to bankruptcy or other problem. In addition, firm also should not have too much equity capital as compared to debt. Othe rproblem may arise such as agency cost. Thus, a carefully selection of gering should be done in order to achievd high performance.

In relation to that, different firm may have different factors need to be considered for determining their gearing. This is because, each firm has their own unique characteristics. There were several studies done on the determinants of capital structure and the findings reveal two way results for each variables positively and negatively. It shows that there is no one specific gearing that fit all. Each and every firm should have their own gearing depend on their characteristics. The determinants include firm’s size, financial policies, assets structure, growth, ownership structure, financial position, financial and business risk, liquidity, industry, transaction cost, dividend policy, macroeconomic factors such as interest rate,tax rate and inflation as well as non-debt tax shield.

Findings from articles also reveal that, not only firm specific characteristics that contribute towards different results in the variables, firm operates in different conutry also have different relation in their gearing. This is due to different policy and environment in each country.

As a conclusion, different firm will have different determinants id determining their gearing. Different country also may lead to different way of determining their gearing. Further studies may be done to examine the capital structures determinant among different countries.

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