Gearing Ratio

Gearing Ratio
Gearing Ratio explained

Gearing Ratio Meaning

A gearing ratio is a financial ratio that measures a company’s financial leverage or risk level. Gearing ratios compare a company’s debt to other financial metrics, such as assets or shareholder equity. Gearing ratios are essential fundamental analysis tools because they give insight into how a company funds its operations and whether it can survive a period of financial instability. 

How to Calculate Gearing Ratio

There are many different gearing ratios, but they all include a company’s debt in their calculations against other financial variables. 

Some of the most common gearing ratios include:

Debt to Equity Ratio

This is the most popular gearing ratio. It measures the total debt against equity. The lower the debt-to-equity ratio, the better, and vice versa. Here is the debt-to-equity ratio formula:

Debt to equity ratio = total debt ÷ total equity

Debt Ratio

The debt ratio measures total debt against total assets. The lower the debt ratio, the better, and vice versa. 

Debt ratio = total debt ÷ total assets.

Equity Ratio

The equity ratio measures total equity against total assets. Unlike other gearing ratios, the higher the equity ratio, the better, and vice versa.

Equity ratio = total equity ÷ total assets

What is a Good or Bad Gearing Ratio?

We will use the net gearing ratio for purposes of illustration. The net gearing ratio is calculated just like the debt-to-equity ratio. Here is the net gearing ratio formula:

Net gearing ratio = (LTD + STD + Bank Overdrafts)/Shareholder Equity * 100

*Where: LTD is long term debt, and STD is short term debt

*The ratio has been multiplied by 100 to express it as a percentage. 

The consensus is that:

  • A ratio of above 50% is considered High. It indicates that a company uses debt to finance its operations and may suffer financial difficulties or even potential bankruptcies during economic recessions or higher interest rates
  • A ratio of below 25% is considered Low. It indicates that a company is financially conservative and uses shareholder equity to finance its operations. Such a company is not at risk of financial difficulties during bad economic times or unfavourable monetary environments. 
  • A ratio of between 25% and 50% is considered Optimal. It indicates that a company is financially responsible and continually seeks to strike a healthy balance between debt and shareholder equity financing its operations. 

Who Uses Gearing Ratios?

Lenders

Lenders use gearing ratios to determine whether a company can repay any loans. A highly geared company is already serving huge debt and may not be a good borrower. Nonetheless, it is essential to note that not all debt is bad. Sometimes companies in high-growth industries can get away with high debt levels. Also, a monopoly that faces no significant threats can afford to be highly geared. 

Investors 

Investors use gearing ratios to establish whether a company is a worthwhile investment. Generally, investors prefer companies with strong balance sheets and low gearing ratios. A highly geared company is servicing huge loans and may not be able to deliver attractive returns to the investor. However, gearing ratios are best compared against the industry average. For instance, if an industry has an average gearing ratio of 80%, a company with a 70% ratio can be considered attractive for an investor.

In contrast, another company with a ratio of 90% can be considered unattractive. Investors might also look at the capital gearing ratio as this tells them about a company’s capital structure. That is, it is the ratio between total equity and total debt, and it enables an investor to establish if a company has the proper capital structure or not.

Management

Management uses the gearing ratio to make important corporate decisions that will reduce the overall financial risk exposure of the company. For instance, a company with a lousy gearing ratio relative to its competitors may decide to negotiate with creditors to convert their debt to equity. Other important decisions that management can make to relieve their financial stress include minimising their cost of operations (cutting expenses) or selling shares to the public. 

Benefits and Limitations of Gearing Ratios

Gearing ratios are a great measure of tracking the financial risk exposure of a company. They help companies manage their debt levels, forecast future sources of risk, and make important corporate decisions. They also help investors and lenders to gauge the risks involved before engaging with any company. 

Still, gearing ratios are not a comprehensive fundamental metric. In some cases, a ratio may show that a company is highly leveraged and may face substantial financial risks, but that may not be the case. This is why gearing ratios must always be viewed within the context of size, history, and industry. In this way, investors and lenders can accurately determine the acceptable gearing level of any company. For instance, a well-established company may be able to absorb more debt without raising eyebrows. 

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FAQ

  • What is the gearing ratio formula?

    Net gearing ratio = (Total Debts/Shareholder Equity) * 100 *The ratio has been multiplied by 100 to express it as a percentage.

     
  • What is a good debt-to-equity ratio?

    The consensus is that a good debt to equity ratio is below 50%. This would mean that a company finances most of its operations through shareholder equity.