Published on 27 May 2024
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.
Summary
Key takeaways
- A gearing ratio compares a company’s capital (or owner equity) to its borrowings
- There are different types of gearing ratio calculations
- It can be an indicator of the level of financial risk to which the business is exposed
- A high gearing ratio may be an indicator of potential risk
Gearing ratio: definition
A gearing ratio measures a company’s equity against its borrowed funds. A company’s gearing ratio is used to help investors, creditors, and analysts to gauge how much leverage the company has in comparison to its equity and how much risk this represents.
Types of gearing ratios
Different types of gearing ratios exist, including the debt-to-equity ratio, the debt ratio, and the equity ratio. Each of these is calculated in a unique way.
Debt to equity ratio
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.
Debt ratio
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.
Equity ratio
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.
Calculation method
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:
Debt to equity ratio = Total liabilities / Total shareholder equity
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:
Debt ratio = Total debts / Total assests
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:
Equity ratio = Total equity / Total assests
A company’s equity includes all its share capital, retained earnings and treasury stock.
Interpreting gearing ratios
Once the gearing ratio has been calculated, it must be interpreted if it is to become a useful metric. A higher gearing ratio is considered to be an indicator of higher leverage and, hence, higher financial risk.
High gearing
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.
Low gearing
A low gearing ratio shows that a company has a smaller proportion of debt to equity and is considered a lower risk for investors and lenders. A gearing ratio below 50% is low.
Industry comparisons
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.
Factors influencing gearing ratios
Business factors
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.
Ratios over time
Gearing ratios can also vary over time. A high gearing ratio may not simply indicate a higher level of debt but may reveal a conscious decision to take out a business loan at a time when interest rates are low.
Economic and market conditions
Gearing ratios can also be influenced by general economic cycles. Spikes in interest rates and slowdowns in the economy can have an impact on companies of all sizes. Over-reliance on debt can lead to companies struggling to remain afloat. Other factors such as market share and potential earnings growth can also impact the gearing ratio.
Capital allocation
Decisions on capital allocation, i.e., where a company’s resources will be distributed and invested is one way that companies can strategically influence their gearing ratio to try to reduce their financial risk.
Conclusion
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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