Gearing Ratio vs. Debt-to-Equity Ratio: An Overview
Gearing ratios form a broad category of financial ratios, of which the debt-to-equity ratio is the predominant example. Accountants, economists, investors, lenders, and company executives all use gearing ratios to measure the relationship between owners' equity and debt. You often see the debt-to-equity ratio called the gearing ratio, although technically it would be more correct to refer to it as a gearing ratio.
All companies have to balance the advantages of leveraging their assets with the disadvantages that come with borrowing risks. This same uncertainty faces investors and lenders who interact with those companies. Gearing ratios are one way to differentiate financially healthy companies from troubled ones.
Key Takeaways
- Gearing ratios constitute a broad category of financial ratios, of which the debt-to-equity ratio is the best example.
- Accountants, economists, investors, and other financial professionals use gearing ratios, as they provide a means of measuring the relationship between owners' equity and debt.
- Gearing ratios are a tool for separating financially healthy companies from troubled ones.
Understanding Gearing Ratio
"Gearing" simply refers to financial leverage. Gearing ratios focus more heavily on the concept of leverage than other ratios used in accounting or investment analysis. The underlying principle generally assumes that some leverage is good, but too much places an organization at risk.
At a fundamental level, gearing is sometimes differentiated from leverage. Leverage refers to the amount of debt incurred for the purpose of investing and obtaining a higher return, while gearing refers to debt along with total equity—or an expression of the percentage of company funding through borrowing. This difference is embodied in the difference between the debt ratio and the debt-to-equity ratio.
Put another way, leverage refers to the use of debt. Gearing is a type of leverage analysis that incorporates the owner's equity, often expressed as a ratio in financial analysis.
Gearing and leverage can often be used interchangeably. Europeans tend to talk about gearing (especially in British English/finance) while Americans refer to it as leverage.
Understanding Debt-to-Equity Ratio
The debt-to-equity ratio compares total liabilities to shareholders' equity. It is one of the most widely and consistently used leverage/gearing ratios, expressing how much suppliers, lenders, and other creditors have committed to the company versus what the shareholders have committed. Different variations of the debt-to-equity ratio exist, and different unofficial standards are used among separate industries. Banks often have preset restrictions on the maximum debt-to-equity ratio of borrowers for different types of businesses defined in debt covenants.
Special Considerations
Debt-to-equity ratio values tend to land between 0.1 (almost no debt relative to equity) and 0.9 (very high levels of debt relative to equity). Most companies aim for a ratio between these two extremes, both for reasons of economic sustainability and to attract investors or lenders. Debt-to-equity, like all gearing ratios, reflects the capital structure of the business. A higher ratio is not always a bad thing, because debt is normally a cheaper source of financing and comes with increased tax advantages.
The size and history of specific companies must be taken into consideration when looking at gearing ratios. Larger, well-established companies can push their liabilities to a higher percentage of their balance sheets without raising serious concerns. Companies that do not have long track records of success are much more sensitive to high debt burdens.
FAQs
The Debt-To-Equity Ratio compares a company's total debt to its shareholders' equity, encompassing both short-term debt and long-term debt and all types of equity. In contrast, the gearing ratio focuses solely on the long-term debt obligations of the company.
What is the difference between gearing and debt-to-equity ratio? ›
The Debt to Equity ratio (also called the “debt-equity ratio”, “risk ratio”, or “gearing”), is a leverage ratio that calculates the weight of total debt and financial liabilities against total shareholders' equity.
What is the difference between debt equity and debt ratio? ›
The key difference between debt ratio and debt to equity ratio is that while debt ratio measures the amount of debt as a proportion of assets, debt to equity ratio calculates how much debt a company has compared to the capital provided by shareholders.
What is the difference between gearing ratio and net gearing ratio? ›
A gearing ratio is a general classification describing a financial ratio that compares some form of owner equity (or capital) to funds borrowed by the company. Net gearing is the most common type of gearing ratio and is calculated by dividing the total debt by the total shareholders' equity.
What is the difference between gearing ratio and leverage ratio? ›
At a fundamental level, gearing is sometimes differentiated from leverage. Leverage refers to the amount of debt incurred for the purpose of investing and obtaining a higher return, while gearing refers to debt along with total equity—or an expression of the percentage of company funding through borrowing.
What is the difference between gearing and LTV? ›
Loan To Value or LTV is a ratio of a company's debts to its total assets. It differs from gearing, which is a measure of a company's debts to its net assets.
Is gearing ratio a debt ratio? ›
Gearing ratios are financial ratios that compare some form of owner's equity (or capital) to debt, or funds borrowed by the company. Gearing is a measurement of the entity's financial leverage, which demonstrates the degree to which a firm's activities are funded by shareholders' funds versus creditors' funds.
What are the 4 main differences between debt and equity? ›
Difference Between Debt and Equity
| Points | Debt | Equity |
|---|
| Repayment | Fixed periodic repayments | No obligation to repay |
| Risk | Lender bears lower risk | Investors bear higher risk |
| Control | Borrower retains control | Shareholders have voting rights |
| Claims on Assets | Secured or unsecured claims on assets | Residual claims on assets |
6 more rowsJun 16, 2023
Gearing shows the extent to which a firm's operations are funded by lenders versus shareholders—in other words, it measures a company's financial leverage. When the proportion of debt-to-equity is great, then a business may be thought of as being highly geared, or highly leveraged.
What is the difference between debt and equity quizlet? ›
What's the difference between debt financing and equity financing? Debt financing raises funds by borrowing. Equity financing raises funds from within the firm through investment of retained earnings, sale of stock to investors, or sale of part ownership to venture capitalists.
Gearing Ratio, also known as the leverage ratio, is a financial metric that measures the degree of a company's financial leverage. It is used to assess the company's long-term solvency by analyzing the proportion of the company's equity and debt financing.
What is the difference between liquidity ratios and gearing ratios? ›
A business with low gearing is one that is funded mostly by share capital (equity) and reserves, while a business with high gearing is mainly funded by loan capital. Liquidity refers to how quickly an asset can be converted into cash. Money in the bank, or held in cash, is the most liquid asset.
What is an example of a gear ratio? ›
The calculation uses the number of teeth in the ring gear and divides it by the number of teeth in the pinion gear to provide you with a “[result] to 1” ratio. For example, if the pinion gear has 41 teeth, and the ring gear has 11 teeth, the ratio would be calculated as 41/11, which is equal to 3.73 = 3.73:1.
What is the difference between equity ratio and gearing ratio? ›
One way to understand how a company is financed is to assess its total debt to equity ratio. Also called a gearing ratio, this is the amount of debt vs. equity that a company uses to finance its operations. A gearing ratio therefore allows the respective weight of total financial debt and equity to be assessed.
What is an example of a gearing ratio? ›
Example of calculating gearing ratio
Let's say a company is in debt by a total of $2 billion and currently hold $1 billion in shareholder equity – the gearing ratio is 2, or 200%. This means that for every $1 in shareholder equity, the company has $2 in debt.
What is the debt to equity ratio? ›
The debt-to-equity (D/E) ratio is used to evaluate a company's financial leverage and is calculated by dividing a company's total liabilities by its shareholder equity. The D/E ratio is an important metric in corporate finance.
Does high gearing mean high debt? ›
A company with a high gearing ratio will tend to use loans to pay for operational costs, which means that it could be exposed to increased risk during economic downturns or interest rate increases. This could lead to financial difficulties, and even bankruptcy.
What is a good gearing ratio? ›
A good gearing ratio depends on the industry the company sits in. While some gearing ratios above 50% are considered high risk, and others say above 100% is high risk, that figure still depends on the context it sits in. For example, a company with a gearing ratio of 60% may be perceived as high risk on its own.
Which ratio of debt-to-equity finance is called gearing? ›
Debt-to-Equity ratio: the most common gearing ratio
It provides a snapshot of a company's financial health by comparing the amount of long-term and short-term debt with shareholders' equity. This ratio is also known as the net gearing ratio or financial leverage.
