Gearing Ratio should be based on market values of debt, equity

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International Accounting Standard (IAS) 1, Presentation of Financial Statements, requires an entity to disclose information that enables users of its financial statements to evaluate the entity’s objectives, policies and processes for managing capital. To comply with this requirement, an entity discloses qualitative information about its objectives, policies and processes for managing capital and also the summary data about what it manages as capital. Usually, entities manage capital structure in the light of changes in the business environment and the risk characteristics of the underlying assets.

Analysts and entities monitor capital on the basis of the debt-to-adjusted capital ratio. This ratio is calculated as net debt divided by adjusted capital. Net debt is calculated as total debt (as shown in the balance sheet) less cash and cash equivalents. Adjusted capital comprises all components of equity (i.e. share capital, share premium, non-controlling interests, retained earnings, and revaluation reserve). Some analysts prefer to exclude revaluation reserve in calculating the amount of equity. Another alternative is to monitor the gearing ratio, which is calculated by dividing net debt by the total of net debt and adjusted equity. 

Classification of debt and equity
Appropriate classification of capital into debt and equity is important for the calculation of the gearing ratio. According to the principles stipulated in IFRS, in case of equity capital the entity has no obligation to repay the originally contributed capital or to pay a return on capital, while in case of debt, the entity has an obligation to repay the capital and to pay a return on capital (interest) as stipulated in the debt covenant.

Therefore, under IFRS, redeemable preference shares are classified as debt, while under the Indian GAAP (schedule VI to the Companies Act), it is classified as equity. Similarly, under IFRS, the proceeds from compound instruments (e.g. convertible debentures) are allocated between equity and debt. Under Indian GAAP, the total proceeds from compound instruments are presented as debt. 

Book value and market value
The gearing ratio is useful for two reasons: first, it gives holders of equity an idea of the extent to which leverage in the firm's financial structure magnifies the volatility of the returns that they get; second, it gives an idea of how likely the firm is to go bankrupt. For both these reasons it is better to use the market value of equity than its book value. In well-functioning capital market values reflect the present value of the firm's future earnings. If the firm’s market value in such a well-functioning market goes up, it is a signal that the firm is going to earn more in the future. But by the very nature of loan from financial institutions and other debt which are not traded in the market, the claims from debt holders will remain unchanged.

Therefore the volatility in the equity-holders' returns and the probability of the firm going bankrupt would now be less and this fact should now be reflected in a decreased gearing ratio. If the debt is traded in the market (e.g. debentures), the market value represents the exit value, that is the price at which the firm can buy back the instrument and extinguish the liability. Therefore, in case of traded debt, the market value is the appropriate measure of the liability and it should be used to calculate the gearing ratio.

Conclusion
Entities should not use gearing ratio calculated on the basis of book values of debt and equity to monitor and manage the capital structure. They should use gearing ratio based on market values of debt and equity. Use of book-value based gearing ratio may lead to sub-optimal use of debt in the capital structure. Banks and other financial institutions should also use the market value based gearing ratio otherwise good assets in their books may appear to be risky assets.

Moreover, the use of the book value of equity in calculating the gearing ratio being monitored by lenders leads to accounting manipulation such as capitalisation of development expenditure, netting of loans against assets, and structuring lease so as to classify it as an operating lease rather than a finance lease. Therefore, it is the high time to have a re-look at the current policy of using book-value based gearing ratio.

Email id: asish.bhattacharyya@gmail.com