Find out how to calculate a gearing ratio, what it’s used for, and its limitations.
What Is a Gearing Ratio?
A gearing ratio is a measurement of a company’s financial leverage, or the amount of business funding that comes from borrowed methods (lenders) versus company owners (shareholders). Well-known gearing ratios include debt-to-equity, debt-to-capital and debt-service ratios. Lenders may use gearing ratios to decide whether or not to extend credit, and investors may use them to determine whether or not to invest in a business. A higher gearing ratio usually indicates higher financial risk. While there is no set gearing ratio that indicates a good or bad structured company, general guidelines suggest that between 25% and 50% is best unless the company needs more debt to operate.
How Do You Calculate a Gearing Ratio?
There are many types of gearing ratios, but a common one to use is the debt-to-equity ratio. To calculate it, you add up the long-term and short-term debt and divide it by the shareholder equity. If you don’t have any shareholders, then you (the owner) are the only shareholder, and the equity in this equation is yours.
How Gearing Ratios Work
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 about 133%, which is generally considered high. Raising capital by continuing to offer more shares would help decrease your gearing ratio. For example, if you managed to raise $50,000 by offering shares, your equity would increase to $125,000, and your gearing ratio would decrease to 80%. Another method to decrease your gearing ratio is to increase your sales in an attempt to increase revenue. You could also try to convince your lenders to convert your debt into shares.
Limitations of Gearing Ratios
The results of gearing ratio analysis can add value to a company’s financial planning when compared over time. But as a one-time calculation, gearing ratios may not provide any real meaning. It’s also important to remember that 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 generally carry more risk, regulated entities such as utility companies commonly operate with higher debt levels. Monopolistic companies often also have a higher gearing ratio because their financial risk is mitigated by their strong industry position. Additionally, capital-intensive industries, such as manufacturing, typically finance expensive equipment with debt, which leads to higher gearing ratios. For this reason, it’s important to consider the industry that the company is operating in when analyzing it’s gearing ratio, because different industries have different standards.
