Gearing ratio explained
Gearing ratios provide an insight into how a company funds its operations, relative to debt and equity. Using gearing ratios as part of your trading fundamental analysis strategy helps to provide crucial financial ratios that can be utilised to make smarter trading decisions. Continue reading to learn about key features of gearing ratios and how they can support your decision-making.
What is a financial gearing ratio?
Financial gearing ratios are a group of popular financial ratios that compare a company’s debt to other financial metrics such as business equity or company assets. Gearing ratios represent a measure of financial leverage that determines to what degree a company’s actions are funded by shareholder equity in comparison with creditors’ funds.
Gearing ratios can be a useful part of fundamental analysis. Gearing ratio calculations help provide clarity into the sourcing of a firm’s operation funding, which provides a greater insight into a company’s reliability and whether they are able to withstand periods of financial instability.
Gearing ratios formula
Each gearing ratio formula is calculated differently, but the majority of the formulas include the firm’s total debts measured against variables such as equities and assets.
Debt to equity ratio
Perhaps the most common method to calculate the gearing ratio of a business is by using the debt to equity measure. Simply put, it is the business’s debt divided by company equity.
Debt to equity ratio = total debt ÷ total equity
The debt to equity ratio can be converted into a percentage by multiplying the fraction by 100. This is perhaps an easier way to understand the gearing of a company and is generally common practice.
Debt to equity percentage = (total debt ÷ total equity) × 100
Debt ratio
Debt ratio is very similar to the debt to equity ratio, but as an alternative, it measures total debt against total assets. This ratio provides a measure to which degree a business’s assets are financed by debt.
Debt ratio = total debts ÷ total assets
Equity ratio
Conversely, equity ratio gives a measure of how financed a firm’s assets are by shareholder’s investments. Unlike the other gearing ratios, a higher percentage is often better.
Equity ratio = total equity ÷ total assets
How to calculate a gearing ratio
Gearing ratios can be calculated to give an indication of how well a business is performing. In order to calculate a debt to equity gearing ratio, you should divide a company’s total debt by total equity. In most gearing ratios, the higher a gearing ratio percentage, the more risk that is associated with the business’s operations.
Calculating gearing ratio example
Let’s say that company ABC has the following financials:
Total Debt: £100,000
Total Equity: £400,000
Company ABC’s debt to equity ratio can be calculated by taking the total debt divided by the total equity, then take the ratio and multiply it by 100 to express the ratio as a percentage.
( £100,000 ÷ £400,000 ( × 100 ) )
= 25% debt to equity ratio
Gearing ratio analysis
The analysis of gearing ratios is a very important aspect of fundamental analysis. Gearing ratios can differ tremendously between industries, so it is often best practice to compare gearing ratios to the industry average, as opposed to comparing companies from different industries or regions.
Please note that the use of debt for financing a firm’s operations is not necessarily a bad thing. The extra income from a loan can help a business to expand its operations, enter new markets and improve business offerings, all of which could improve profitability in the long term.
On the contrary, a business with an extremely low gearing ratio could not be taking expansion opportunities when interest rates are low, ultimately losing out on growth opportunities that their competitors may take. Therefore, gearing ratios are not a comprehensive measure of a business’s health and are just a fraction of the full picture. Make sure to use gearing ratios as part of your fundamental analysis, but not as a standalone measure and always utilise the ratios on a case-by-case basis.
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High gearing ratio vs low gearing ratio
As mentioned above, when measuring the quality of a company’s gearing ratio, it is suggested that you measure against competitors in the same industry as they can vary wildly across industries. Below are some basic guidelines for analysing high and low gearing ratios:
- A high gearing ratio that exceeds 50%. A gearing ratio that exceeds this amount would represent a highly geared (or highly levered) company. The company would be more at risk during times of financial instability, as debt financing would increase a business’s risk during economic downturns or interest rates spikes.
- A mid-level gearing ratio between 25% and 50%. A gearing ratio that is mid-level is known to be normal for well-established companies.
- A low gearing ratio below 25%. Investors, lenders and any other parties analysing the financial documents would see a gearing ratio below 25% as very low risk.
Control and manage gearing ratio
There are several ways a company can try to indirectly manage and control its gearing ratio, usually by profit, debt and expense management.
- Debt management. Perhaps the most obvious is debt management. If a company manages their debt efficiently, they should be able to reduce their gearing ratio. Companies can take steps to pay off their debt and thus, incur less interest long term. Firms can also utilise debt management schemes to avoid taking out more loans. Additionally, firms should attempt to re-negotiate debt terms in a bid to reduce long-term liabilities.
- Increasing profits. Increasing profits will help to increase stock price and thus, shareholder equity. Conversely, sometimes taking out loans, in this case, can help a business become more profitable in the long term.
- Reducing expenses. Expense reduction will decrease liabilities and therefore improve the gearing ratio. Reducing expenses can include anything from renegotiating loan terms, increasing business efficiency and introducing basic cost controls.
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