Gearing ratios are financial metrics that compare some form of owner’s equity (or capital) to debt—funds borrowed by the company. Gearing measures an entity’s financial leverage, demonstrating the degree to which a firm’s activities are funded by shareholders’ funds versus creditors’ funds.
The gearing ratio is a crucial measurement that showcases how a firm’s operations are financed—whether through equity capital or debt financing.
Key Takeaways:
- Assessment of Leverage and Stability: Gearing ratios compare shareholders’ equity to company debt, providing insights into a company’s level of leverage and financial stability.
- Funding Dynamics: These ratios bring clarity about how much of the company’s operations are financed by debt versus equity from shareholders.
- Industry Benchmarks: Gearing ratios reveal their true significance when compared against the ratios of other companies in the same industry.
Understanding Gearing Ratios
Examples of well-known gearing ratios include:
-
Debt-to-Equity Ratio
1Debt-to-Equity Ratio = \frac{\text{Total Debt}}{\text{Total Equity}} -
Times Interest Earned
1Times Interest Earned = \frac{\text{EBIT}}{\text{Total Interest}} -
Equity Ratio
1Equity Ratio = \frac{\text{Equity}}{\text{Assets}} -
Debt Ratio
1Debt Ratio = \frac{\text{Total Debt}}{\text{Total Assets}}
A higher gearing ratio signifies higher financial leverage, making a company more susceptible to economic downturns and business cycles. This happens because companies with more debt compared to shareholders’ equity must service higher amounts of debt, unlike their counterparts with lesser leverage.
Gearing ratios hold significant value for both internal and external parties. Financial institutions leverage these calculations when deciding on loan issuance. Often, loan agreements come with specific guidelines regarding acceptable gearing ratio levels. Internally, management relies on these ratios to devise strategies for future cash flows and handle leverage effectively.
Interpreting Gearing Ratios
A high gearing ratio indicates a significant level of leverage, though this doesn’t necessarily equate to poor financial health. Instead, it denotes a riskier financing structure. Regulated entities and industries reliant on expensive fixed assets typically sustain higher gearing ratios because their strategic positions reduce the risk of default.
Inspiration from an Example of Gearing Ratios
Imagine a company has a debt ratio of 0.6. While this figure alone can provide some insight, benchmarking it against industry peers yields greater understanding.
For illustration, consider the company’s debt ratio last year was 0.3, the industry average stands at 0.8, and the main competitor has a ratio of 0.9. In such a scenario, with the industry averaging at 0.8 and the competition at 0.9, a firm with a 0.3 ratio is comparatively excelling in its industry sector.
Related Terms: Debt-to-Equity Ratio, Times Interest Earned, Equity Ratio, Debt Ratio.
