Gearing Ratios: What Is a Good Ratio, and How to Calculate It

A gearing ratio is a financial ratio that compares some form of capital or owner equity to funds borrowed by the company. Gearing is a measurement of a company's financial leverage. As such, the gearing ratio is one of the most popular methods of evaluating a company's financial fitness. This article tells you everything you need to know about these ratios, including the best one to use.

Gearing Ratios: An Overview

Gearing ratios are important financial metrics because they can help investors and analysts understand how much leverage a company has compared to its equity. Put simply, it tells you how much a company's operations are funded by a form of equity versus debt.

Lenders use gearing ratios to make important lending decisions. They're also useful for corporate managers who can use them to make important decisions about cash flows and leverage. Here's how these ratios are interpreted:

• High Gearing Ratio: The company has a larger proportion of debt versus equity
• Low Gearing Ratio: The company has a small proportion of debt versus equity

There are several variations of the gearing ratio. They include the equity ratio, debt-to-capital ratio, debt service ratio, and net gearing ratio. These ratios are calculated using different formulas.

The Most Common: Net Gearing Ratio

The net gearing ratio is the most commonly used gearing ratio in financial markets. Most investors know this as a company's debt-to-equity (D/E) ratio. The D/E ratio measures how much a company is funded by debt versus how much is financed by equity. Put simply, it compares a company's total debt obligations to its shareholder equity.

The debt portion in the net gearing ratio may include the following:

• Short-term debt
• Long-term debt
• Accrued debt
• Accounts payable (AP)
• Financing agreements
• Leases
  

It's important to compare the net gearing ratios of competing companies—that is, companies that operate within the same industry. That's because each industry has its own capital needs and relies on different growth rates.

How to Calculate the Net Gearing Ratio

The net gearing ratio (as a debt-to-equity ratio) is calculated by:

$\begin{aligned} &\text{Net Gearing Ratio} = \frac { \text{LTD} + \text{STD} + \text{Bank Overdrafts} }{ \text{Shareholders' Equity} } \\ &\textbf{where:} \\ &\text{LTD} = \text{Long-Term Debt} \\ &\text{STD} = \text{Short-Term Debt} \\ \end{aligned}$​Net Gearing Ratio=Shareholders’ EquityLTD+STD+Bank Overdrafts​where:LTD=Long-Term DebtSTD=Short-Term Debt​

Net gearing can also be calculated by dividing the total debt by the total shareholders' equity. The ratio, expressed as a percentage, 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. Here are a few basic guidelines for good and bad gearing ratios:

• Higher Than 50%: A gearing ratio that falls in this range 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.
• Between 25% and 50%: A gearing ratio within this range is typically considered optimal or normal for well-established companies.
• Lower Than 25%: Gearing ratios that fall under this value are typically considered low-risk by both investors and lenders.
  

Gearing Ratios and Risk

The gearing ratio is an indicator of the financial risk associated with a company. If a company has too much debt, it has the potential to fall into financial distress. Remember: A high gearing ratio shows a high proportion of debt to equity, while a low gearing ratio shows the opposite.

Gearing ratios reflect the levels of risk involved with the company. Capital that comes from creditors is riskier than money from the company's owners since creditors still have to be paid back even if the business doesn't generate income. 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. 

Keep in mind that debt can help a company expand its operations, add new products and services, and ultimately boost profits if invested properly. Conversely, a company that never borrows might be missing out on an opportunity to grow its business by not taking advantage of a cheap form of financing, especially when interest rates are low. 

Capital-intensive companies or those with a lot of fixed assets, like industrials, are likely to have more debt versus companies with fewer fixed assets. For example, utility companies typically have a high, acceptable gearing ratio since the industry is regulated. These companies have a monopoly in their market, which makes their debt less risky companies in a competitive market with the same debt levels.

The Bottom Line

A safe gearing ratio can vary by 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.