Gearing ratio definition

What is a gearing ratio?

A gearing ratio is a measure used by investors to establish a company’s financial leverage. In this context, leverage is the amount of funds acquired through creditor loans – or debt – compared to the funds acquired through equity capital.

A gearing ratio is usually expressed as a percentage. A high gearing ratio is anything above 50%, while a low gearing ratio is anything below 25%. Between 25% and 50% is considered the optimal gearing ratio.

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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. However, there are ways that a company can pay off its debts and reduce its gearing ratio, such as:

  • Using an appropriate strategy to increase profits
  • Selling more shares to the public to increase shareholder equity
  • Reducing operational costs

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. It will often use shareholders’ equity to pay for major costs. Shareholders’ equity is a cash amount calculated by subtracting a company’s total liabilities from its total assets.

Example of calculating gearing ratio

The most common way to calculate gearing ratio is by using the debt-to-equity ratio, which is a company’s debt divided by its equity.

For example, if a company has $2 billion in debt and $1 billion in shareholder equity, the gearing ratio is 2, or 200%. This means that for every $1 in shareholder equity, the company has $2 in debt.

Pros and cons of gearing ratios

Pros of gearing ratios

A gearing ratio is a useful measure for the financial institutions that issue loans, because it can be used as a guideline for risk. When an organisation has more debt, there is a higher risk of financial troubles and even bankruptcy.

Gearing ratios are also a convenient way for the company itself to manage its debt levels, predict future cash flow and monitor its leverage.

Cons of gearing ratios

Using a company’s gearing ratio to gauge its financial structure does have its limitations. This is because the gearing ratio could reflect a risky financial structure, but not necessarily a poor financial state. While the figure gives some insight into the company’s financials, it should always be compared against historical company ratios and competitors’ ratios.

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