Gearing ratios are financial metrics that evaluate the relationship between a company's equity or capital and its borrowed funds or debt. These ratios serve as indicators of financial leverage, reflecting the extent to which a business's operations are financed through shareholders' equity compared to funds sourced from creditors.
What is the gearing ratio?
Gearing ratios are financial metrics used to assess the proportion of a company's equity or capital in relation to its debt or borrowed funds. It is helpful to see how much debt a company has and the proportion of its operations that is funded by debt. When a company has a higher gearing ratio, it means that the company is more financially at risk as it has a large proportion of debt as compared with equity.
The higher the gearing ratio, the chances are that the company has a lot of loans to repay paving the way for more interest amount, which needs to be paid and thus, would cause them financial burden in case revenues don't flow in. Conversely, a low gearing ratio is an indicator that the company relies less on debt and more on equity to finance its operations. For this reason, the gearing ratio is of particular interest to investors and creditors who want a better understanding of just how financially stable or risky the company they are investing in actually is.
Formula of Gearing ratio
Depending upon what aspects of a company’s debt and equity are compared, the formula for gearing ratio can change. But the most common formula used is:
Gearing Ratio = (Total Debt / Shareholders' Equity) x 100
The result from applying this formula gives the gearing ratio in percentage. This indicates how much per cent of the company’s operations is financed by debt as compared to equity.
Let’s say a company’s total debt is Rs. 10 crore, the shareholder’s equity is Rs. 25 crore, then the gearing ratio will be:
(10 crore / 25 crore) x 100 = 40%
This means that 40% of the company’s operations are financed through debt.
How to calculate gearing ratio?
- Calculate the total debt of the company including short-term and long-term.
- Now arrive at the shareholder’s equity by calculating the difference between total assets and total liabilities.
- Now apply the formula for the gearing ratio which is (Total Debt / Shareholders' Equity) x 100.
- Now, analyse the result which is in percentage form, to see how much financial risk the company is at and figure out its risk profile.
What is a good gearing ratio?
A good gearing ratio will vary from one industry to another and also depends on the specific financial strategy being followed by a company. A gearing ratio of less than 50% is usually said to be healthy and suggests that the company does not depend too much on debt for its functioning. A moderate gearing ratio indicates a healthy combination of debt and equity.
On the contrary, some industries have other norms. For example, utility companies will have higher gearing ratios, since they operate in a capital-intensive industry, however, with their earnings come fairly consistent cash flows. Whereas, companies in highly uncertain sectors would be prudent to carry lower gearing ratios so as to have the ability to survive when markets don't perform.
You also may want to factor in the debt cost. If a company has a high gearing ratio, it could be less worrying if it were able to obtain low-interest loans. Similarly, low-geared firms may benefit from higher-interest debt.
Good and bad gearing ratios
Good gearing ratios
A gearing ratio is typically considered “good” when it falls in the range of 25% to 50%, but this can change depending upon the specific industry. It shows that the company is funding itself partially, which is 50% with equity (its own money), and the rest in debt so that its finance has some flexibility. A healthy gearing ratio provides the company with all of the advantages of financial leverage, including tax-deductible interest payments. Good gearing ratios are desired as companies with weak cash flows or perceived financial stability will fail to attract investors.
Bad gearing ratios
A gearing ratio over 50% would be considered risky, especially if it is above industry standards. Higher debt with respect to equity suggests that the company is running heavily on borrowed funds. This could result in major financial issues if the cash flow decreases or interest rates increase. This could possibly lead such companies to bankruptcy as high gearing ratios mean low ability to pay off debt. On the other hand, a low gearing ratio may be interpreted as an indication that the company is not entirely benefitting from leverage to expand its operations, and this situation could reduce its growth capability.
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What does the gearing ratio say about risk?
Gearing ratio is a crucial financial risk indicator. A company with a higher gearing ratio relies on debt to finance its day-to-day operations. As the company relies more on debt to finance its operations, it may end up paying higher interest expenses — a financial drain that could quickly become unsustainable if revenue falls all of a sudden or if there is an increase in interest rates. High gearing ratios are riskier, as it implies that the company in question has less financial flexibility and, hence, is more susceptible to economic downturn.
A low gearing ratio, on the other hand, suggests that a company depends more heavily on equity than debt. The debt settlement lessens financial pressure which means it has fewer commitments to its creditors and can mostly weather any money problems. On the other hand, not enough debt can also be a failure to take advantage of opportunities by being unable to leverage its growth with borrowed funds.
Pros and cons of gearing ratios
Pros
Insight into financial risk: The gearing ratio helps stakeholders make an informed decision about the risks associated with the company by giving a clear picture of its financial leverage.
Benchmarking tool: Within the same industry, it helps investors compare companies for their financial health.
Cons
Varies by industry: Gearing ratios of companies across industries cannot be compared as they have different norms.
Oversimplification: The gearing ratio does not consider cash flow, market conditions and other such factors that can impact the financial risks of a company.
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Who uses gearing ratios?
Gearing ratios are essential financial tools used by various stakeholders to evaluate a company’s financial health, risk profile, and operational efficiency. These ratios help lenders, investors, and management make informed decisions regarding lending, investing, or strategising to optimise financial stability.
Lenders
Lenders utilise gearing ratios to assess a company's capacity to repay loans. Companies with high gearing are often heavily indebted, making them less reliable borrowers. However, it’s important to recognise that not all debt is negative. Businesses in rapidly growing sectors may effectively manage high debt levels, while monopolies with minimal competition can sustain elevated gearing ratios without significant risk.
Investors
Investors use gearing ratios to determine whether a company offers a promising investment opportunity. Generally, companies with strong balance sheets and lower gearing ratios are more attractive, as they allocate fewer resources to debt servicing and have greater potential to deliver returns.
Management
Management leverages gearing ratios to make strategic decisions aimed at improving the company’s financial position. A business with an unfavourable gearing ratio compared to competitors might negotiate with creditors to convert debt into equity. Other measures to ease financial strain could include reducing operational expenses or issuing shares to raise capital.
Gearing ratio analysis
Gearing ratio analysis is a key part of fundamental analysis. Since these ratios vary widely across industries, it is best to compare them to industry averages rather than across different sectors or regions. Using debt to finance operations isn’t always negative; it can support business growth, market expansion, and improved offerings, enhancing profitability. However, companies with very low gearing ratios may miss growth opportunities, especially during periods of low interest rates, giving competitors an advantage. While gearing ratios are valuable, they should not be used in isolation but as part of a broader analysis.
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Control and manage gearing ratio
Effectively managing a company’s gearing ratio is essential for maintaining financial stability and minimising risk. This involves strategies focused on optimising debt, increasing profitability, and controlling expenses to achieve a balanced capital structure.
- Debt management
One of the most direct ways to manage the gearing ratio is through efficient debt management. Companies can lower their gearing ratio by paying off existing debt, thereby reducing interest expenses over time. Firms may also explore debt management plans to avoid accumulating additional loans. Renegotiating loan terms can further help reduce long-term liabilities and improve financial flexibility. - Increasing profits
Boosting profitability contributes to a stronger equity base and positively impacts the gearing ratio. Higher profits can lead to an increased stock price and greater shareholder equity. In some cases, strategically taking on loans can help a company invest in growth opportunities, ultimately improving long-term profitability. - Reducing expenses
Cutting costs is another effective way to manage the gearing ratio. Lower expenses decrease liabilities, thereby improving financial ratios. This can include renegotiating existing debt terms, improving operational efficiency, and implementing cost-control measures to streamline business operations.
Interpreting gearing ratios
While a high gearing ratio might be reasonable for a company in stable, capital-intensive industries, it could make the same company look financially troubled in a more volatile industry. Investors and analysts should further take into account changes in the gearing ratio over time; if a company's gearing is increasing, it may be taking on more financial risk, whereas a falling ratio might suggest that its financial stability has improved.
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Example of how to use gearing ratios
Let’s say there are two companies, A and B in the same industry. If company A has a gearing ratio of 30% and company B has a gearing ratio of 70%, then company A may be considered less risky than company B because it has a lower debt requirement. If company B's debt is used to fund projects with high returns, it has the potential for larger rewards despite the higher risk.
Limitations of gearing ratios
Gearing ratios are valuable for assessing a company’s financial risk, managing debt levels, and supporting corporate decision-making. They also assist investors and lenders in evaluating potential risks. However, these ratios are not standalone indicators of financial health. A high gearing ratio might suggest significant financial risk, but this may not always be true. To gain accurate insights, gearing ratios must be analysed in the context of the company’s size, history, and industry. For instance, established firms often have a higher capacity to manage debt without raising concerns.
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Key takeaways
- Gearing ratio is a financial tool that compares a company’s debt to its equity.
- If the gearing ratio is high in a company, it means that it has more debt to repay than equity and so, it is at a higher financial risk and vice versa.
- An investor, before investing in the company, will assess the risk profile of the company, and thus will look at the gearing ratio.
Conclusion
The gearing ratio of a company represents a crucial constituent for financial analysis, providing information on the extent to which the said company is making use of debts to function. If investors and business managers understand the gearing ratio meaning, formula, and calculation, consequently they can make more informed decisions.
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