What is a Gearing Ratio?
Gearing Ratio Definition
The gearing ratio is a financial metric that assesses the proportion of a company’s debt in relation to its equity.
It measures how much a company relies on debt to finance its operations and investments, as opposed to using its own equity or shareholder funds.
The gearing ratio is also known as the debt-to-equity ratio, or the leverage ratio.
Gearing Ratio Formula
Now that we understand what a gearing ratio is, the next step is to understand how to calculate the gearing ratio.
The gearing ratio can be calculated using the following formula:
Gearing Ratio = (Total Debt / Shareholder Equity) x 100
Where:
Total Debt = all outstanding loans, bonds, and other forms of debt a company owes.
Shareholder Equity = the total value of the shareholders’ ownership in the company.
Gearing Ratio Interpretation
The gearing ratio is expressed as a percentage.
A high gearing ratio indicates that a business has a significant amount of debt relative to its equity, suggesting a higher financial risk.
On the other hand, a low gearing ratio suggests a more cautious approach with less reliance on debt.
Why is Debt Financing Considered Riskier Than Equity Financing?
Debt financing is generally considered riskier because it requires regular repayment of the borrowed money, which can strain a company’s finances, especially if it faces difficulties.
For example, a business may take out a loan with a bank for £500,000 where the annual interest rate is 7% over 10 years.
This would mean that the monthly interest payments would be around £5,750.
If the business falls into financial difficulty and fails to repay the debt, the businesses credit rating could be severely affected, or they could even be declared bankrupt or fall into administration.
In contrast, equity financing doesn’t have the same obligations for regular debt repayments, making it a less risky option in challenging situations.
Gearing Ratio Examples
To further explain this concept, let’s look at some examples of how we can use the formula to calculate the gearing ratio:
Example 1: High Gearing Ratio
Let’s assume that Company A has total debt of £4 million and shareholder equity of £2 million.
Using the gearing ratio formula:
Gearing Ratio = (£4,000,000 / £2,000,000) x 100 = 200%
In this case, Company A’s gearing ratio is 200%, indicating that it relies heavily on debt to finance its operations and investments.
This high gearing ratio implies greater financial risk because a larger portion of the company’s capital structure is debt-based.
Example 2: Low Gearing Ratio
Now, let’s consider Company B, which has total debt of £1 million and shareholder equity of £5 million.
Using the gearing ratio formula:
Gearing Ratio = (£1,000,000 / £5,000,000) x 100 = 20%
Company B’s gearing ratio is 20%, signifying a less risky approach with a lower reliance on debt.
A low gearing ratio suggests that the company has a more stable financial structure and is less exposed to the risks associated with high levels of debt.
Significance of the Gearing Ratio
The gearing ratio is used in a variety of ways:
- Risk Assessment
It helps investors, creditors, and management assess the financial risk associated with a company.
For example, a high gearing ratio may indicate greater financial uncertainty, while a low ratio suggests more financial stability.
- Capital Structure Analysis
The ratio provides insights into a company’s capital structure.
Companies with different gearing ratios may have varying strategies for financing their growth and operations.
- Comparison
The gearing ratio can be used to compare companies within the same industry or sector.
It allows stakeholders to evaluate how a company’s financial leverage stacks up against its peers.
- Decision Making
Businesses can use the gearing ratio when making decisions about raising additional capital, acquiring assets, or paying off debt.
A thorough understanding of the gearing ratio can guide strategic financial choices.
Comparing Gearing Ratios
Let’s take a deeper look into how the gearing ratio can be used to compare two businesses.
Assume that Retail Company X and Manufacturing Company Y operate in different industries and have separate financial profiles.
Retail Company X has a gearing ratio of 50%, indicating moderate reliance on debt to support its business operations.
On the other hand, Manufacturing Company Y, has a gearing ratio of 80%, which indicates a higher level of debt.
Suppose both companies are considering expanding their operations.
Retail Company X, with its lower gearing ratio, may have an easier time securing additional debt financing at favourable interest rates.
Whereas Manufacturing Company Y might face challenges due to its already high gearing ratio, which could result in higher borrowing costs.
Additionally, investors assessing the risk associated with each company may be more inclined to invest in Retail Company X due to its lower financial risk as indicated by the gearing ratio.
What is a Good Gearing Ratio?
A “good” gearing ratio depends on a number of individual factors, such as the industry, business model, economic conditions, and risk tolerance of a business.
For example, industries with stable cash flows (such as utilities) can handle higher gearing ratios, whereas industries with fluctuating revenues (such as technology startups) may choose lower ratios to reduce risk.
There is no one size fits all answer to this question, but in very general terms:
- Low Gearing Ratio (Conservative)
A low gearing ratio, typically below 50%, suggests that a company has relatively low levels of debt compared to its equity.
This is often seen as conservative and less risky because the company has a lower financial commitment to repay debt.
- Moderate Gearing Ratio (Balanced)
A gearing ratio between 50% and 100% strikes a balanced mix of debt and equity.
This can be considered a moderate or healthy gearing ratio for many businesses, as it suggests a reasonable level of leverage without overloading the company with debt.
- High Gearing Ratio (Aggressive)
A high gearing ratio, above 100%, means the company has more debt than equity.
Taking on a large amount of debt could be part of an aggressive growth strategy, which could amplify returns in the good times.
However, a high gearing ratio poses a high risk, especially if the company faces financial challenges which means they may struggle to keep up with their debt repayments.