A gearing ratio is a financial ratio that compares some form of capital or ownerequityto funds borrowed by the company.Gearingis a measurement of a company'sfinancialleverage. As such, the gearingratio is one of the most popular methods of evaluating a company's financial fitness. This article tells you everything you need to know about these ratios, including the best one to use.
Key Takeaways
- A gearing ratio is a general classification describing a financial ratio that compares some form of ownerequity(or capital) to funds borrowed by the company.
- Net gearing is the most common type of gearing ratio and is calculated bydividing the total debtby the total shareholders' equity.
- Anoptimal gearing ratio is primarilydetermined by the individual company relative to other companies within the same industry.
Gearing Ratios: An Overview
Gearing ratios are important financial metrics because they can help investors and analysts understand how much leverage a company has compared to its equity. Put simply, it tells you how much a company's operations are funded by a form of equity versus debt.
Lenders use gearing ratios to make important lending decisions. They're also useful for corporate managers who can use them to make important decisions about cash flows and leverage. Here's how these ratios are interpreted:
- High Gearing Ratio: The company has a largerproportion of debt versusequity
- Low Gearing Ratio: The company has a smallproportion of debt versusequity
There are several variations of the gearing ratio. They include the equity ratio, debt-to-capital ratio, debt service ratio, and net gearing ratio. These ratios are calculated using different formulas.
In some cases, high net gearing ratios may be a red flag. But they may be common for companies in certain industries. Businesses that rely heavily on leverage to invest in property or manufacturing equipment often have high D/E ratios.
The Most Common: Net Gearing Ratio
The net gearing ratio is the most commonly used gearing ratio in financial markets. Most investors know this as a company's debt-to-equity (D/E) ratio. The D/E ratio measures how much a company is funded by debt versus how much is financedby equity.Put simply, it compares a company's total debt obligations to its shareholder equity.
The debt portion in the net gearing ratio may include the following:
- Short-term debt
- Long-term debt
- Accrued debt
- Accounts payable (AP)
- Financing agreements
- Leases
It's important to compare the net gearing ratios of competing companies—that is, companies that operate within the same industry. That's because each industry has its own capital needs and relies on different growth rates.
How toCalculate the Net Gearing Ratio
The net gearing ratio (as a debt-to-equity ratio) is calculated by:
NetGearingRatio=Shareholders’EquityLTD+STD+BankOverdraftswhere:LTD=Long-TermDebtSTD=Short-TermDebt
Net gearing can also be calculated bydividing the total debtby the total shareholders' equity.Theratio, expressed as a percentage, reflects the amount of existing equity that would be required to pay off all outstanding debts.
Capital gearingis a British term that refers to the amount of debt a company has relative to its equity. In the United States, capital gearing is known as financial leverageand is synonymous withthe net gearing ratio.
Good andBad Gearing Ratios
Anoptimal gearing ratio is primarilydetermined by the individual company relative to other companies within the same industry. Here are a fewbasic guidelines for good and bad gearing ratios:
- Higher Than 50%: Agearing ratio that falls in this range is typically considered highly levered or geared. As a result, the company would be at greaterfinancial risk, because during times of lowerprofits and higherinterest rates, the company would be more susceptible to loan default andbankruptcy.
- Between 25% and50%: A gearing ratio within this range is typically considered optimal ornormal for well-established companies.
- Lower Than 25%:Gearing ratios that fall under this value are typically considered low-risk by both investors and lenders.
| Gearing Ratio Guidelines | |
|---|---|
| 50% or more | High-levered, high risk |
| 25% to 50% | Optimal or normal |
| 25% or Less | Low-levered, low risk |
Gearing Ratios and Risk
The gearingratio is an indicator of thefinancial risk associated witha company. If a company has too much debt, it has the potential to fallinto financial distress. Remember: A high gearing ratio shows a high proportion of debt to equity, while a low gearing ratio shows the opposite.
Gearing ratios reflectthe levels of risk involved with thecompany.Capitalthat comes from creditors is riskier than money from the company'sownerssince creditors still have to be paid back even if the business doesn't generate income. A company with too much debtmight be at risk ofdefault or bankruptcyespecially if theloans havevariable interest rates and there's asudden jump inrates.
Keep in mind that debt can help a company expand its operations, add new products and services,and ultimately boostprofits if invested properly. Conversely, a companythat never borrows might be missing out on anopportunity to grow its business by not takingadvantageof a cheapform of financing, especially when interest ratesare low.
Capital-intensive companies or those with a lot of fixed assets, like industrials, are likely to have more debt versuscompanies with fewer fixed assets. For example, utility companies typically haveahigh, acceptable gearing ratio since the industry is regulated. These companies have a monopoly in their market, which makes their debtless risky companies in a competitive market with the same debt levels.
Why Are Gearing Ratios Important?
Gearing ratios are financial metrics that compare a company's debt to some form of its capital or equity. They indicate the degree to which a company's operations are funded by its debt versus its equity. They also highlight the financial risk companies assume when they borrow to fund their operations. High ratios may be a red flag while low ratios generally indicate that a company is low-risk.
What Does the Net Gearing Ratio Tell You?
The net gearing ratio is the most common gearing ratio used by analysts, lenders, and investors. Also called the debt-to-equity ratio, it measures how much of the company's operations are funded by debt compared to its equity.
Is it Better to Have a High Gearing Ratio?
A high gearing ratio can be a blessing or a curse—depending on the company and industry. Having a high gearing ratio means that a company is using more debt to fund its operations, which may increase the financial risk. But high ratios may work well for certain companies, especially if they are capital-intensive as it shows they are investing in their growth.
The Bottom Line
A safe gearing ratio can vary by companyand is largely determinedby how a company's debt is managed and how well the company is performing.Many factors should be considered when analyzing gearing ratiossuch as earnings growth, market share, and the cash flow of the company.
It's also worth considering thatwell-established companies might be able to pay off their debt by issuing equityif needed. In other words, having debt on their balance sheet might be a strategic business decisionsince it might mean less equity financing. Fewer shares outstanding can result inlessshare dilution and potentially lead to anelevatedstock price.
