Gearing ratio is one way to measure a company’s financial health. It involves comparing the capital to the amount of money the company has borrowed.
It is an indicator of how “levered” the company is. In other words, it refers to the extent to which debt finances the operations of a company.
A high gearing ratio shows that a company has a high level of debt compared to its equity. Depending on the industry, this may (or may not) be an indicator of financial risk.
The debt-to-equity ratio, sometimes abbreviated to the “D/E ratio,” is an important financial metric that indicates a company’s level of debt compared to its shareholder equity.
The D/E ratio is calculated by dividing a company’s total liabilities (debts) by its shareholder or owner equity. It indicates the extent to which the company’s operations are being funded by its own resources rather than by its debts.
The D/E ratio tells potential investors, creditors, or analysts the level of debt that the company owes compared to its shareholder equity. A high D/E ratio indicates that the company is borrowing more capital from the market to fund its operations, while a low D/E ratio is borrowing less from the market and is using its own assets to fund its operations.
Another way of measuring a company’s financial leverage is by analysing its debt ratio. This is simply a measurement of the company’s total debt compared to its total assets.
A company’s debt ratio can be given in the form of a decimal or a percentage. A debt ratio greater than 1 (or 100%) shows that the company has more liabilities than assets. A ratio below 1 (or 100%) shows that a greater proportion of its operations are funded by equity.
The debt ratio must be interpreted with care and is highly industry dependent. A debt ratio of 30% may be considered too high in an industry where companies do not take on a great deal of debt, while a higher ratio may be easily managed by a company in another industry where high debt levels are commonplace.
The equity ratio is another gearing ratio used to measure financial leverage. It is a metric which uses a company’s total assets and total equity to find out how leveraged a company is.
The equity ratio is usually given as a decimal and anything which is 0.50 or below generally indicates that the company is leveraged. The higher the equity ratio, the less leveraged the company is and the more likely investors and lenders are to consider that the company represents a safe investment.
A high equity ratio shows that the company is in good financial health and is likely to be able to repay its debts.
These different gearing ratios are calculated in different ways, and all provide information on how leveraged a company is.
For example, in public limited companies, and other stock companies, the debt-to-equity ratio is measured by dividing the company’s total liabilities by its total shareholder equity. The formula for calculating the debt-to-equity ratio is as follows:
The total liabilities include all the company’s debts, both long- and short-term as well as any other liabilities, such as deferred tax liabilities. The shareholder equity is calculated by subtracting total liabilities from total assets.
To take a practical example, an SME may have total liabilities amounting to €10,000. Its total shareholder equity is €6,000. The debt-to-equity ratio for this company is calculated by dividing the total liabilities (€10,000) by the total shareholder equity (€6,000), which gives a debt-to-equity ratio of 1.6
The formula for calculating the debt ratio is as follows:
Again, the total debts include long- and short-term debts as well as any deferred debts and fixed payment obligations. A company’s total assets include such things as accounts receivable, inventories and commodities owned by the company.
The equity ratio can be represented by the following formula:
Regardless of the method used to calculate it, a company with a high gearing ratio is one which is depends more highly on debt to fund its investments and operations. This may increase its financial risk.
A company with a gearing ratio over 50% is usually considered highly leveraged and high risk.
In order to establish a company’s optimum gearing ratio, comparisons must be made with other companies operating in the same sector.
For example, if a company has a gearing ratio of 65%, this might be considered as high risk. But if the company’s leading competitor has a gearing ratio of 80% then it might be seen in a better light. Similarly, if the average gearing ratio across the sector is 70%, then this particular company might be considered lower risk.
Businesses operating in capital-intensive industries such as utilities and telecommunications often have high gearing ratios.
Various business factors can influence a company’s gearing ratio. A company which adopts an aggressive business model might naturally accumulate more debt. This may be a positive or a negative development, depending on the other elements of the business, such as its equity and assets. Several strategies can be adopted to reduce a company’s gearing ratio, including selling shares, converting loans, reducing working capital and increasing profits.
Businesses operating in capital-intensive industries such as utilities and telecommunications often have high gearing ratios.
Calculating gearing ratios is a valuable metric that can be used by investors, lenders, and analysts to measure financial risk. The ratios can also be used by businesses themselves, however, to gauge their financial health, manage their debt levels and predict future cash flows.
Although it is a useful tool and can give insight into a company’s financial situation, it should never be considered in isolation. A broader picture over time and considering competitors in the industry is required.
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