What Is the Gearing Ratio?
Gearing ratios are financial ratios that compare some form of owner's equity (or capital) to debt, or funds borrowed by the company. Gearing is a measurement of the entity’s financial leverage, which demonstrates the degree to which a firm's activities are funded by shareholders' funds versus creditors' funds.
The gearing ratio is a measure of financial leverage that demonstrates the degree to which a firm's operations are funded by equity capital versus debt financing.
- Gearing ratios are a group of financial metrics that compare shareholders' equity to company debt in various ways to assess the company's amount of leverage and financial stability.
- Gearing is a measure of how much of a company's operations are funded using debt versus the funding received from shareholders as equity.
- Gearing ratios have more meaning when they are compared against the gearing ratios of other companies in the same industry.
Understanding Gearing Ratios
The best known examples of gearing ratios include:
Debt-to-Equity Ratio=Total EquityTotal Debt
Times Interest Earned*=Total InterestEBIT
Debt Ratio=Total AssetsTotal Debt
A higher gearing ratio indicates that a company has a higher degree of financial leverage and is more susceptible to downturns in the economy and the business cycle. This is because companies that have higher leverage have higher amounts of debt compared to shareholders' equity. Entities with a high gearing ratio have higher amounts of debt to service, while companies with lower gearing ratio calculations have more equity to rely on for financing.
Gearing ratios are useful for both internal and external parties. Financial institutions use gearing ratio calculations when deciding whether to issue loans. In addition, loan agreements may require companies to operate with specified guidelines regarding acceptable gearing ratio calculations. Alternatively, internal management uses gearing ratios to analyze future cash flows and leverage.
Interpreting Gearing Ratios
A high gearing ratio typically indicates a high degree of leverage, although this does not always indicate a company is in poor financial condition. Instead, a company with a high gearing ratio has a riskier financing structure than a company with a lower gearing ratio.
Regulated entities typically have higher gearing ratios as they can operate with higher levels of debt. In addition, companies in monopolistic situations often operate with higher gearing ratios as their strategic marketing position puts them at a lower risk of default. Finally, industries that use expensive fixed assets typically have higher gearing ratios, as these fixed assets are often financed with debt.
A firm's gearing ratio should be compared with the rations of other companies in the same industry.
Example of How to Use Gearing Ratios
Assume that a company has a debt ratio of 0.6. Although this figure alone provides some information as to the company’s financial structure, it is more meaningful to benchmark this figure against another company in the same industry.
For instance, assume the company's debt ratio last year was 0.3, the industry average is 0.8, and the company’s main competitor has a debt ratio of 0.9. More information is derived from the use of comparing gearing ratios to each other. When the industry average ratio result is 0.8, and the competition's gearing ratio result is 0.9, a company with a 0.3 ratio is, comparatively, performing well in its industry.