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. Gearing is a measurement of a company's financial leverage, and the gearing ratio is one of the most popular methods of evaluating a company's financial fitness.
Though there are several variations, the most common ratio measures how much a company is funded by debt versus how much is financed by equity, often called the net gearing ratio. A high gearing ratio means the company has a larger proportion of debt versus equity. Conversely, a low gearing ratio means the company has a small proportion of debt versus equity.
Capital gearing is a British term that refers to the amount of debt a company has relative to its equity. In the United States, capital gearing is known as financial leverage and is synonymous with the net gearing ratio.
What Is A Good Gearing Ratio?
How to Calculate the Net Gearing Ratio
The net gearing ratio is calculated by:
Net gearing can also be calculated by dividing the total debt by the total shareholders' equity. Expressed as a percentage, the ratio reflects the amount of existing equity that would be required to pay off all outstanding debts.
Good and Bad Gearing Ratios
An optimal gearing ratio is primarily determined by the individual company relative to other companies within the same industry. However, here are a few basic guidelines for good and bad gearing ratios:
- A gearing ratio higher than 50% is typically considered highly levered or geared. As a result, the company would be at greater financial risk, because during times of lower profits and higher interest rates, the company would be more susceptible to loan default and bankruptcy.
- A gearing ratio lower than 25% is typically considered low-risk by both investors and lenders.
- A gearing ratio between 25% and 50% is typically considered optimal or normal for well-established companies.
What Does the Gearing Ratio Say About Risk?
The gearing ratio is an indicator of the financial risk associated with a company. If a company has too much debt, it can fall into financial distress.
A high gearing ratio shows a high proportion of debt to equity, while a low gearing ratio shows the opposite. Capital that comes from creditors is riskier than money that comes from the company's owners since creditors still have to be paid back regardless of whether the business is generating income. Both lenders and investors scrutinize a company's gearing ratios because they reflect the levels of risk involved with the company. A company with too much debt might be at risk of default or bankruptcy especially if the loans have variable interest rates and there's a sudden jump in rates.
However, debt financing, or the use of leverage, is not necessarily a red flag. If invested properly, debt can help a company expand its operations, add new products and services, and ultimately boost profits. Conversely, a company that never borrows might be missing out on an opportunity to grow their business by not taking advantage of a cheap form of financing, if interest rates are low.
It's important to compare a company's gearing ratio to companies in the same industry. Companies that are capital intensive or have a lot of fixed assets, like industrials, are likely to have more debt versus companies with fewer fixed assets.
For example, utilities would typically have a high gearing ratio but might be considered acceptable since it's a regulated industry. Utilities have a monopoly in their market making their debt less risky than a company with the same debt levels, which operates in a competitive market.
Typically, a low gearing ratio means a company is financially stable, but not all debt is bad debt.
It's essential for companies to manage their debt levels. However, it's also important that companies put their assets on their balance sheets to work, including using debt to boost earnings and profits for their shareholders.
A safe gearing ratio can vary from company to company and is largely determined by how a company's debt is managed and how well the company is performing. Many factors should be considered when analyzing gearing ratios such as earnings growth, market share, and the cash flow of the company.
It's also worth considering that well-established companies might be able to pay off their debt by issuing equity if needed. In other words, having debt on their balance sheet might be a strategic business decision since it might mean less equity financing. Fewer shares outstanding can result in less share dilution and potentially lead to an elevated stock price.
Please read "Gearing Ratios" for other types of gearing ratios.