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.
What a Gearing Ratio Is
"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. This conceptual focus prevents gearing ratios from being precisely calculated or interpreted with uniformity. 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 owner's equity, often expressed as a ratio in financial analysis.
How Debt-To-Equity Factors Into Gearing
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.
What This Means for Companies
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, reflect 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.
The Bottom Line
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 the financially healthy companies from troubled ones.