What is a Financial Gearing Ratio?

What is a Financial Gearing Ratio?

 Reading time: 6 minutes

The gearing ratio is an essential financial indicator used to determine a company's financial leverage, or ‘gearing’.

Investors, lenders, and stakeholders monitor leverage ratios to understand the company's ability to fund its primary operations using debt obligations. The ratio provides insights into the company's financial health and risk profile and can be used to compare it with other companies in the industry.

 Types of Gearing Ratios

  • Debt-to-Equity Ratio (D/E) or Net Gearing Ratio

D/E is the most common leverage ratio, found by dividing the total liabilities of the business by the total shareholders’ equity. The main idea behind this formula is to determine how much of a company’s capital structure is used to fund its operations. In other words, is it leaning more towards debt financing or equity financing?

This ratio can also be referred to as the Net Gearing Ratio and can be shown through both short and long formulas, as below:

Debt-to-Equity Ratio = Total Debt / Total Shareholders’ Equity

(Long-Term Debt + Short-Term Debt + Bank Overdrafts) / Total Shareholders’ Equity

As an example, should company XYZ have US$100 million in total debt liabilities (located on the company’s Balance Sheet) and a total shareholders’ equity of US$220 million, the D/E ratio for this company would be 0.45. So, for every dollar in equity, 45 cents are financed through debt. This can easily be converted into a percentage: 45.0% = (0.45 x 100).

❖  A high gearing ratio indicates a higher debt relative to equity. A gearing ratio of 50% and above is considered highly geared or highly leveraged. This means that the company might face financial difficulties and high risks during events such as economic downturns or increases in interest rates.

❖  A low gearing ratio, less than 25%, indicates lower debt relative to equity. It suggests that the company does not rely on external funds and is, therefore, less vulnerable to financial risks.

❖  An optimal gearing ratio of a financially fit company lies between 25% and 50%. It shows that the company is using a fair amount of debt to finance its business operations and at the same time is maintaining a strong equity position.

  • Debt-to-Assets Ratio

The Debt-to-Assets Ratio, also known as the Debt Ratio, is another leverage ratio used to determine a company’s capital structure. Essentially, the ratio indicates the portion of debt (interest-bearing debt) the company uses to fund its operations (the proportion of assets that are financed through debt).

A Debt Ratio above 1.0 or 100% indicates that a company funds a large portion of its assets through debt (so, greater liabilities than assets), which can be a sign of greater financial risk of default. A Debt Ratio below 1.0 indicates that the company is not as reliant on debt to fund its assets and, thus, less likely to experience default (according to this ratio). A targeted Debt Ratio among investors sits around the 0.4 value.

Debt Ratio = Total Debt / Total Assets

A fictional Debt Ratio of the company XYZ might be as follows:

Total debt = US$100 million

Total assets = US$120 million

Therefore, the Debt Ratio for this company is below 1.0: 0.83 (rounded).

  • Debt-to-Capital Ratio (D/C)

The D/C ratio measures the proportion of debt a company uses to fund its ongoing operational and functional costs. Unlike the D/E ratio, it measures how much leverage a company employs by dividing total debt liabilities by total liabilities (total debt and total shareholders’ equity). It provides a good way of measuring a company’s risk.

Debt-to-Capital Ratio = Total Debt / Total Debt + Total Shareholder’s Equity

By way of an example, imagine company XYZ has a total debt of US$100 million and total liabilities of US$130 million. This would produce a D/C ratio of 0.77 (rounded). To make sense of this, the company is funded more with debt rather than equity—77%, to be exact. 

The Bottom Line

Ultimately, gearing ratios are used as one of the risk guidelines to determine whether or not a company is worth investing in. A highly geared company has high debt levels and might be at risk of financial distress or bankruptcy. Companies with low gearing ratios are generally preferred as they are financially conservative and not at risk during economic uncertainties.

However, sometimes, debt is not all that bad. A monopoly company can be highly geared and yet amplify profits. High ratios can also work in favour of companies that effectively use loans to invest in projects that yield a greater return than the debt. However, like all financial ratios, including gearing ratios, a lot of context is required. For example, it is recommended to compare ratios between companies within the same industry to determine their gearing levels accurately. 

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Source - database | Page ID - 38940

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