What Is a Gearing Ratio?
What Does Gearing Ratio Mean, and How Is It Calculated?
A gearing ratio is a type of financial ratio that compares company debt relative to different financial metrics, such as total equity. Investors sometimes use these types of ratios to assess how a company structures itself, and the amount of risk involved with the chosen structure.
This is similar to the debt to equity ratio, which is a financial structuring indicator (how much debt or equity if funding the company), as well as a gearing ratio. Gearing represents a company's leverage, meaning how much of the business funding comes from borrowed methods (lenders) versus company owners (shareholders).
Understanding Financial Leverage and Financial Risk
A company's financial leverage represents its use of borrowed money to increase sales volume, thereby increasing revenues. Business owners may increase financial leverage with a bank loan that allows them to purchase necessary equipment. Financial risk represents the additional risk of default when a company expands its use of financial leverage.
Although financial leverage and financial risk are not the same, they are interrelated. Measuring the degree to which a company uses financial leverage, or growing its business with borrowed funds provides an easily calculated way of assessing the company's financial risk.
Calculating the Gearing Ratio
While there is no set ratio that indicates a good or bad structured company, it is a good idea to keep your gearing ratio as low as you can. General guidelines for gearing ratios state that between 25% and 50% is best unless more debt is needed to operate.
A general way to calculate the gearing ratio is to add up all of the company's debts and divide them by shareholder's equity. If you do not have any shareholders, then you (the owner) are the only shareholder, and the equity in this equation is yours.
(All Long - Term Debt + All Short - Term Debt) ÷ Shareholders' Equity
These debts could include any number of sources, as long as they are in the form of borrowed funds.
Long-term debt examples are loans, leases or any other form of debt that requires payments at least a year out. Short term debts are the same loans and leases but are those that require payments within a year.
The same loan could be both short and long-term if it lasts longer than one year. The portion that is due within a year is short-term debt, and the portion due a year or more out is long-term debt.
The results of gearing ratio analysis can add value to a company's financial planning when compared over time. As a one-time calculation, gearing ratios may not provide any real meaning.
For lenders, the gearing ratio is important. It indicates to them whether the company has taken on too much debt. This is meaningful to lenders because if a company requested a loan, but had a high gearing ratio, there is a high possibility of that company not paying the loan back.
Example Gearing Ratio
If your company had $100,000 in debt, and your balance sheet showed $75,000 of shareholders' or owners' equity, then your gearing ratio would be very high, 130%. However, if you managed to raise $50,000 by offering shares, your equity would increase to $125,000.
Your gearing ratio would decrease to 80%—this is still high. Raising capital by continuing to offer more shares would continue to decrease your gearing ratio. However, this is not the only method.
Another method to decrease your gearing ratio is to increase your sales in an attempt to increase revenues. You could also try to convince your lenders to convert your debt into shares, turning your debt into equity.
Although high gearing ratio results indicate high financial leverage, they don't always mean that a company is in financial distress. While firms with higher gearing ratios do have more risk, regulated entities such as utility companies commonly operate with higher debt levels.
Monopolistic companies often also have higher gearing ratio because their financial risk is mitigated by their strong industry position. Additionally, capital-intensive industries (e.g., manufacturing) typically finance expensive equipment with debt, which leads to higher gearing ratios.