Understanding Gearing Ratio: Definition, Formula & Examples

Published on
November 17, 2023
Written by
Aaron Oh
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Episode #
Understanding Gearing Ratio: Definition, Formula & Examples
Explore the intricacies of gearing ratios: its significance, calculation, analysis, & contrast with other metrics. Use it to assess a firm's financial health.
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Welcome! You're here because you want to understand one of the most important financial metrics - the gearing ratio. This ratio is an indispensable tool investors, lenders, and companies use to assess financial health.

But what is it? How is it calculated? And why should you care?

In this article, we explore the gearing ratio, explain why it’s important and why it is considered a key indicator of financial stability. We’ll also examine how the gearing ratio compares to other financial metrics, discuss what is deemed as an optimal gearing ratio and address the potential limitations of its use.

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.

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. 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.

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.

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ABOUT THE AUTHOR
Aaron Oh is a seasoned content writer specialising in finance, insurance and tech industries. With a writing history at S&P Global, EdgeProp, Indeed, Prudential, and others, Aaron leverages finance knowledge and business insights to help businesses improve productivity and performance.
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