Understanding Gearing Ratio: Definition, Formula & Examples

What is a Gearing Ratio?

The gearing ratio measures a company's financial leverage as a percentage. It reveals the proportion of a company's capital funded by debt. In simpler terms, it shows how much a company relies on borrowed money to finance its operations and growth. Businesses can typically use gearing ratio to assess their financial stability and evaluate the risk profile of their business.

As such, a firm’s gearing ratio can fluctuate significantly based on its industry and stage of development. For instance, start-ups and rapidly growing companies often have high gearing ratios because they need to borrow heavily to finance their expansion. On the other hand, established companies with steady cash flows tend to have lower gearing ratios.

Why is the Gearing Ratio Important?

A company’s gearing ratio is used by a wide range of stakeholders, including investors, lenders, and analysts. Investors use it to evaluate the risk and return potential of a company. Lenders use it to assess a company's ability to repay its debts, while analysts use it to compare companies within the same industry or sector.

The gearing ratio is a powerful tool because it provides insights into a company's financial structure and risk profile. A high gearing ratio suggests a company has significant debt, which could be a red flag for potential investors or lenders. Conversely, a low gearing ratio indicates that a company is primarily financed by equity, which may suggest a more conservative approach to financing.

What Can the Gearing Ratio Tell Us?

The net gearing ratio is a tool that helps assess a company's financial leverage, specifically its ability to meet long-term obligations. It calculates the proportion of a company's debt compared to equity. A higher ratio indicates higher financial risk yet potentially higher returns. Conversely, a lower net gearing ratio may signify financial stability but potentially lower returns. Finding the optimal gearing ratio helps investors understand a company's financial health and risk level.

What Are the Risks Associated with Gearing Ratios?

If a company's gearing ratio is high, it exposes itself to various financial risks, such as the ones mentioned below.

If a company's gearing ratio is high, it is more vulnerable to cash flow shortages, which can make it challenging to fulfil its obligations.

A company's financial flexibility is also affected when the gearing ratio is high. This is because a company's ability to obtain additional capital or adjust its business strategies without increasing debt becomes a challenge.
Another risk associated with a high gearing ratio is the rise in interest rates. A high gearing ratio increases a company's exposure to inflation. The cash flow reduces if most of the company's funds go towards fulfilling its debt obligations.

That said, a low gearing ratio doesn't mean that a company's structural health in terms of capital is represented. For instance, in certain industries, especially cyclical or capital-intensive industries, debt is often used to finance operations. This high reliance on debt makes achieving a low gearing ratio highly improbable. 

As with any other financial metric, a gearing ratio that is too high or too low presents multiple financial challenges. Therefore, a company's gearing ratio must align with its industry and growth strategy. Also, all companies must carefully manage the risks mentioned above to ensure they maintain an ideal gearing ratio.

How to Calculate Gearing Ratio?

Here, we explore how to compute the gearing ratio using debt and shareholder's equity. 

Long term debt

The long-term debt gearing ratio is a financial metric that calculates the proportion of a company's long-term debts to its equity capital. This ratio is used to understand the financial leverage of a company, where 'leverage' refers to the amount of funds acquired through debt compared to shareholders' equity, or equity. It gives insights into the financial risk associated with the company in terms of its long-term obligations. The formula for calculating long-term debt is:

This formula calculates the firm's long-term debt proportion to its total capital, i.e., the sum of long-term debt and equity. Expressed as a percentage, it indicates the degree to which a company is funded by debt versus equity.

Short term debt

The short-term debt gearing ratio is a specific type of gearing ratio that focuses on a company's short-term debt. It is a measure of financial leverage that shows how much of the company's operations are financed by short-term debt compared to equity. The gearing ratio formula for calculating short-term debt is:

Total debt

The total debt gearing ratio is a financial indicator that illustrates the percentage of a company's debt with its overall funding, including both equity and debt. It's a measure of financial leverage, indicating the extent to which a company is funded by debt. This ratio helps investors and lenders understand the financial risk associated with the company's debt level. The gearing ratio formula for calculating total debt is:

Shareholders' equity

Shareholder's equity, also known as net assets or net worth, signifies the residual value to shareholders after a company's debts are paid and assets liquidated. The formula for calculating shareholders' equity is:

Examples of How to Use Gearing Ratio

Let’s consider a hypothetical company. The company has long-term debt of $10 million, short-term debt of $5 million, and shareholders’ equity of $15 million. With the formulas provided above, we can determine the subsequent gearing ratios.

• Long-term debt: (10 / (10 + 15)) x 100% = 40%
• Short-term debt: (5 / (5 + 15)) x 100% = 25%
• Total debt: (15 / (15 + 15)) x 100% = 50%

These ratios tell us that the company finances itself with 40% long-term, 25% short-term, and 50% total debt.

Most Common Gearing Ratio Formula

The most common gearing ratio is net gearing ratio. Also called the debt-to-equity ratio, this metric provides significant insights into a company's financial leverage. It is calculated by dividing a company's total debt by its total shareholders' equity, as defined in the Total Debt formula above. The net gearing ratio helps assess the financial risk and the company's ability to repay its obligations, and plays a crucial role in investment and lending decisions.

What is a Good or Bad Gearing Ratio?

Gearing ratios offer insightful perspectives into a company’s capital structure and financial risk. But what is an optimal gearing ratio, and what do the numbers mean? Read on to find out.

What is a good gearing ratio?

A "good" gearing ratio isn't one-size-fits-all—it differs per industry and depends on the company's growth phase. However, a general rule of thumb is that a gearing ratio of 50% or less is considered healthy, while a ratio of more than 50% could be a cause for concern.

What is a bad gearing ratio?

A "bad" gearing ratio, much like its counterpart, varies by industry and business stage. Generally, a gearing ratio exceeding 50% may be viewed as "bad" or risky, indicating a firm's high reliance on borrowed funds. This over-dependence can lead to financial instability and vulnerability to market fluctuations.

High Gearing Ratio vs Low Gearing Ratio

Deciphering the implications of high and low gearing ratios is crucial for understanding a company's financial health and growth prospects.

What does a high gearing ratio mean?

A high gearing ratio indicates that a large portion of a company's capital comes from debt. 

This might indicate a financial hazard for the company, as it must make enough profits to meet its debt obligations. However, it could also signal growth potential, as companies often take on debt to invest in new projects or acquisitions.

What does a low gearing ratio mean?

A low gearing ratio suggests that a company is primarily financed by equity. This could signify financial stability, as the company relies less on external financing. However, it could also indicate a lack of growth opportunities, as companies often use equity financing when not investing heavily in new projects.

Types of Gearing Ratios: A Comparison With Other Ratios

Here is a comparison of how the gearing ratio compares to other financial ratios:

Gearing Ratio vs. Debt Ratio

While both gearing and debt ratios measure a company's financial leverage, they focus on different aspects of a company's financial structure. The gearing ratio, commonly known as the debt-to-equity ratio compares a company's debt to its shareholder's equity (total assets - current liabilities). On the other hand, the debt ratio looks at a company's total liabilities (both short-term and long-term) and compares it to its total assets. Both ratios provide insights into a company's financial risk and stability but from different perspectives.

Gearing Ratio vs. Current Ratio

Gearing and current ratios are financial indicators that assess different elements of a company's fiscal stability. While the gearing ratio assesses a company's financial leverage, the current ratio is a tool that determines if a company can cover its short-term debts using its immediate assets. It is a metric to measure the short-term financial stability of a company. Thus, while both ratios are financial metrics, they highlight different aspects of a company's financial status.

Gearing Ratio vs. Solvency Ratio

The gearing and solvency ratios are similar in that they both measure a company's ability to meet its long-term financial obligations. However, the solvency ratio also considers a company's cash flow, which is its capacity to produce sufficient funds for immediate and long-term commitments. You can calculate this ratio by dividing a company's after-tax net operating income by its total debt obligations, providing a more comprehensive picture of its financial health.

Gearing Ratio vs. Leverage Ratio

Gearing and leverage ratios measure a company's reliance on debt and its financial risk profile. The gearing ratio depicts how much of a company's capital is financed by debt and its level of financial leverage. On the other hand, the leverage ratio shows a company's degree of debt in relation to its equity, assets, and other metrics. It essentially shows a company's ability to fulfill its financial obligations and the extent to which debt is used to fuel its operations. This ratio can be calculated by dividing a company's total debt by its total equity or total assets.

Gearing Ratio vs. Other Ratios

Gearing ratios are just one of many financial ratios that investors and analysts use to evaluate a company's financial health. Other important ratios include the return on equity ratio (ROE), the price-to-earnings (P/E) ratio, and the dividend yield ratio. While these metrics focus on profitability, earnings, and shareholder returns, the gearing ratio uniquely evaluates the balance of debt and equity in a company's financial structure, providing insight into its leverage and risk levels.

Impact of Economic Conditions on Gearing Ratio 

Certain economic conditions affect a company's gearing ratio, and they are as follows.

Economic conditions 

The level of economic growth also influences the gearing ratio. During economic expansion or boom, there is a general feeling of optimism that few companies and businesses believe they can easily repay. This results in increased borrowing or debt financing, which increases the gearing ratio. Conversely, during economic downturns or recessions, most businesses become risks and look for equity financing options to reduce their debt levels. This reduces the gearing ratio as well.

Interest rate

The cost of debt is directly proportional to the prevalent interest rates. If the interest rates are high, borrowing becomes expensive and reduces the company's willingness to take on more debt. By increasing the focus on equity financing, reliance on debt reduces, reducing the gearing ratio. On the other hand, if the interest rate reduces, more companies would be inclined to take on debt to finance their operations, growth, and expansion, resulting in higher gearing ratios.

Market volatility 

When the market is volatile, investors normally become more risk averse. In such instances, companies might have to work harder to reduce their gearing ratios since a higher ratio signal increased financial risk. To showcase financial stability, companies will have to reduce their gearing ratios.

Debt Financing vs. Equity Financing: Impact on Gearing Ratio

The gearing ratio measures a company's debt level in relation to its equity. This financial metric showcases the company's leverage and financial risk. Both debt and equity financing directly influence this ratio, and here's how they do it. 

Debt financing 

Financing essentially refers to obtaining funds through different means of borrowing, including loans and bonds that need to be repaid at an interest rate. A company's liabilities automatically increase when it opts for debt financing. Increased debt increases the liabilities, which increases the gearing ratio. This is usually an indicator of increased financial risk. Simultaneously, it might also mean the company is using leverage to grow.

For instance, let's assume the company has a debt of $5 million and equity of $2 million. Using the gearing ratio formula, the ratio will be 250%.

Equity financing 

A company raises capital through equity financing by selling its shares to potential investors. Doing this ensures there is an influx of funds without increasing its debt levels. As with debt, even equity levels change the gearing ratio. An increased reliance on equity financing means the gearing ratio reduces. It showcases reduced financial risk, which means the company is less reliant on debt. For instance, let's assume a company has an equity of $2 million and erasers and an additional $1 million through equity capital, and its debt stays at $5 million. In this instance, the gain ratio will be 166.67%.

How can Companies Reduce Their Gearing?

Companies can reduce their gearing by deploying several strategies. First, they can generate more income to pay off debts, thereby reducing the debt-to-equity ratio. Second, they can issue more equity to dilute the proportion of debt in the capital structure. Lastly, they can restructure or refinance their debt to secure more favorable terms, potentially lowering the overall debt level. Each method requires careful planning and execution, with the goal of achieving a more balanced and sustainable financial structure.

Ways Companies Manage Their Gearing Ratio

CEOs and finance experts use different strategies to efficiently handle their company's gearing ratio. They may decide to limit new debt acquisition, thus maintaining or lowering the ratio. Another approach is to reinvest profits back into the business instead of taking on additional liabilities. Companies may also opt for equity financing over debt for new projects. Furthermore, improving operational efficiency to increase profitability can help service existing debts.

Limitations of Using Gearing Ratio

While gearing ratios are valuable for evaluating a company's financial health, it has limitations. For instance, it does not consider a company's profitability or cash flow, which are critical factors in assessing a company's ability to repay its debts. Additionally, the company’s gearing ratio is a static measure that does not reflect changes in a company's financial position over time.

Despite these limitations, the gearing ratio remains a key metric for investors, lenders, and analysts. By understanding how to calculate and interpret this ratio, you can gain valuable insights into a company's financial structure, risk profile, and growth potential.

Manage Your Expenses Effectively with Aspire

With Aspire’s expense management, you can:

• Automate your accounting to close books 2x faster, reducing manual errors with our automated accounting software  
• Say goodbye to receipt chasing and store all your company expenses in one central place
• Control spending by setting budgets for projects, clients, or teams. 

So why wait? Get your Aspire Business account up and running for free in just 5 minutes!

Frequently Asked Questions

1. Can Gearing Ratios Be Improved?

Absolutely, gearing ratios in Singapore can be enhanced by companies through strategic debt management, augmenting equity via the issuance of new shares, or by reducing existing debt. This enables them to leverage additional capital while sustaining a robust financial standing, particularly within the regulatory parameters established by the Monetary Authority of Singapore (MAS) for Singapore REITs (S-REITs), which permits a maximum gearing ratio of 50%.

2. How does working capital relate to gearing ratios?

A gearing ratio displays the percentage of debt to equity, suggesting a company's long-term financial risk, whereas working capital compares current assets and current obligations to assess its short-term financial health. While a high gearing ratio can put strain on a company, a good working capital can assist it handle its debt commitments.

3. Why do gearing ratios vary by industry?

Different industries need different amounts of capital. For example, utilities and telecommunications need to make big upfront investments in fixed assets, so their gearing ratios are usually higher because they need to borrow money to pay for these big costs. On the other hand, industries that don't need as much capital may have lower gearing ratios. Basically, the stability and predictability of a company's cash flow is a big factor in figuring out how much debt it can comfortably handle.

4. How does a high gearing ratio affect a business?

A high gearing ratio signifies that a company is substantially dependent on debt financing, which can increase the risk of financial instability during recessions. It can also lead to increase in interest rate, as the company encounters higher interest payments and may find it challenging to fulfill its obligations to creditors. This can potentially result in bankruptcy or default if revenue declines; fundamentally, a high gearing ratio renders a business more susceptible to financial instability and diminishes its capacity to adapt to fluctuating market conditions.

5. Can a high gearing ratio be a good thing?

A high gearing ratio indicates that a firm is using a greater amount of debt to fund its operations, which may result in an increase in the business's exposure to financial risk. However, higher ratios are beneficial for certain businesses, particularly those that operate in areas that require a significant amount of capital. This indicates that they are making investments in expansion.

6. What happens if a company has a negative gearing ratio?

When a company's negative gearing ratio is greater than its interest cost on its debt, it means that it is managing its debt well and making extra money from investments. Most of the time, this is a good sign for a company's finances because it means it is handling its debt well and making extra money from investments. It could also mean that the company isn't making the best use of its money by not investing more in businesses that could bring in more money.