What is a good or bad gearing ratio?
A good or bad gearing ratio is completely relative, as it is a comparison between an individual company and other companies in the same industry. However, there are some basic guidelines that can be used to identify desirable and undesirable ratios:
- A high gearing ratio is anything above 50%
- A low gearing ratio is anything below 25%
- An optimal gearing ratio is anything between 25% and 50%
A company with a high gearing ratio will tend to use loans to pay for operational costs, which means that it could be exposed to increased risk during economic downturns or interest rate increases. This could lead to financial difficulties, and even bankruptcy.
A company with a low gearing ratio will generally have more conservative spending habits or operate in a cyclical industry – one that is more sensitive to economic ups and downs – so it tries to keep its debts down. Companies with low gearing ratios maintain this by using shareholders’ equity to pay for major costs.