What Are Gearing Ratios?
Gearing ratios represent a group of 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 creditor's funds.
Gearing ratios are a measure of financial leverage that demonstrates the degree to which a firm's operations are funded by equity capital versus debt financing.
What Do Gearing Ratios Tell You?
The best known examples of gearing ratios include the debt-to-equity ratio (total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and debt ratio (total debt / total assets).
Higher gearing ratios indicate 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 as compared to shareholders' equity. Entities with high gearing ratio results have higher amounts of debt to service, while companies with lower gearing ratio calculations have more equity to rely upon for financing is needed.
Gearing ratios are useful for both internal and external parties. Financial institutions utilize gearing ratio calculations in preparation of issuing loans. In addition, loan agreements may require companies to operate with specified guidelines regarding acceptable gearing ratio calculations. Alternatively, internal management utilizes 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 are able to 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 utilize expensive fixed assets typically have higher gearing ratios, as these fixed assets typically are financed with debt.
- 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 used to compare against 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 or the 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 very well in its industry.