A guide to the gearing ratio

Market trader analysing data
Rebecca Cattlin
By :  ,  Financial Writer

What is a gearing ratio?

A gearing ratio is a type of financial ratio that compares a company’s debt to other metrics, such as equity or assets. It’s used to measure a company’s leverage, which shows how much of a company’s operations are funded by equity compared to debt.

There are a few types of gearing ratios, which we’ll get into the formulas of in a moment, but they’re all used to get clarity into the source of a firm’s funding. This can provide us with a key indication of how well a company will be able to withstand periods of financial instability and economic downturn.

The gearing ratio is an indicator of financial risk. While the use of debt or leverage on its own is not a cause for concern – most companies at one time or another will need to use loans to fund expansions and other projects – the risk comes if a company has too much debt that it’s unable to pay off. This means it’s more likely to fall into financial distress and may even be at risk of bankruptcy.

Learn about other financial ratios 

How to calculate a gearing ratio

Calculating a gearing ratio ultimately depends on which type you want to use, as the formulas vary. All gearing ratios measure debt against a secondary metric, the most common two are equity and assets.

So for all of them, you’ll need to first identify a company’s debt level by finding the sum of a company’s long-term debt, short-term debt and any bank overdrafts – all of these figures should be on the firm’s latest earnings report.

Learn how to read an earnings report

Once you know the total debt, you’ll also need to know what you’re comparing it to. This can require a bit more research into a company’s financials. For example, you might need to calculate the total shareholder equity, which is the net worth of a company or the total amount that would be returned to shareholders if a company’s assets were liquidated.

 

Gearing ratio formula

As mentioned, the gearing ratio formula will vary depending on the exact measure you’re looking at. The most common gearing ratio is also known as the debt-to-equity ratio, or the D/E ratio, which compares a company’s total debt against its shareholder equity. It provides insight into how a company’s operations are funded and how capable the firm is of paying its current debts. 

The debt-to-equity ratio formula is:

D/E = total liabilities ÷ shareholder equity

The ratio is expressed as a percentage and tells us how much of the existing equity would be able to pay off any outstanding debt.

  • A high gearing ratio – typically greater than 50% - means the company has a larger proportion of debt than equity, so would not be able to pay down its debt
  • A normal gearing ratio is usually between 25-50%, it shows a balance of equity and debt which is typical for most companies going through expansionary periods
  • A low gearing ratio – less than 25% - indicates that the company has a smaller proportion of debt to equity and could pay liabilities if required. It’s considered a lower risk

However, you could also use other types of gearing or leverage ratios, such as the debt ratio. Instead of looking at equity, the debt ratio is a measure of a company’s total debt against its total assets, expressed as a decimal or percentage. It shows us how much of a company’s assets are financed by its debt.

The debt ratio formula is:

Debt ratio = total debts ÷ total assets

A debt ratio less than 1 or 100% would tell us that a greater portion of the company’s assets is funded by equity than by debt, while a debt ratio greater than 1 or 100% would indicate that the company has more liabilities than assets. This could mean it’s at a greater risk of defaulting on its loans if interest rates were to suddenly be raised.

What is a good gearing ratio?

A good gearing ratio will ultimately depend on how a company stacks up when compared to others within the same industry. So, it’s important to do your research and look at why your chosen company might have a higher or lower gearing ratio compared to its peers and stocks in other sectors.

It’s important to be aware that a high gearing ratio can be extremely common in certain industries that are more capital intensive. This means that it requires much higher financial resources to produce the end goods, and a lot of this capital has to come from debts if a company is new or expanding. For example, telecommunications firms often have high gearing ratios because they must make substantial initial investments in infrastructure before they can deliver any services to consumers.

But gearing ratios will change over time. That’s why more established, larger players in an industry will have lower gearing ratios compared to their peers. Once initial investments have been paid down, the company can start taking any revenue made as profit, rather than paying off its debt.

 

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