Understanding Gearing Ratios: Definitions, Types, and Calculations

What Are Gearing Ratios?

Gearing ratios compare some form of owner’s equity or capital to debt or funds borrowed by the company. They are financial ratios that are critical for assessing a business’s financial stability and leverage.

Types of gearing ratios include debt, debt-to-equity, equity, and times interest earned ratios. A gearing ratio is most meaningful when used as a benchmark against another company in the same industry.

The higher the gearing ratio, the more financial leverage a company has. The lower the gearing ratio, the more a company may turn to equity for financing.

An In-Depth Look at Gearing Ratios

The best-known examples of gearing ratios include:

$\begin{aligned}&\text{Debt-to-Equity Ratio}=\frac{\text{Total Debt}}{\text{Total Equity}}\\\\&\text{Times Interest Earned}=\frac{\text{EBIT}}{\text{Total Interest}}\\\\&\text{Equity Ratio}=\frac{\text{Equity}}{\text{Assets}}\\\\&\text{Debt Ratio}=\frac{\text{Total Debt}}{\text{Total Assets}}\end{aligned}$​Debt-to-Equity Ratio=Total EquityTotal Debt​Times Interest Earned=Total InterestEBIT​Equity Ratio=AssetsEquity​Debt Ratio=Total AssetsTotal Debt​​
A higher gearing ratio means a company has more financial leverage. Such companies are more vulnerable to economic downturns because they have more debt relative to equity. Companies with high gearing ratios have more debt to manage. Companies with lower gearing ratios rely more on equity for financing.
Both internal and external parties find gearing ratios useful. Financial institutions use gearing ratios to decide whether to issue loans. Loan agreements may require companies to meet specific gearing ratio guidelines. Managers use gearing ratios to assess future cash flows and leverage.

How to Interpret Gearing Ratios Effectively

A high gearing ratio usually means high leverage, but it doesn’t always signal poor financial health. A company with a high gearing ratio has a riskier financing structure than a company with a lower gearing ratio. Regulated entities typically have higher gearing ratios because they can operate with higher levels of debt.

Companies in monopolistic situations often operate with higher gearing ratios because their strategic marketing position puts them at a lower risk of default. Industries that use expensive fixed assets typically have higher gearing ratios because these fixed assets are often financed with debt.

Practical Examples: Applying Gearing Ratios

Assume that a company has a debt ratio of 0.6. This figure alone provides some information as to the company’s financial structure, but it’s more meaningful to benchmark it against another company in the same industry.

The company’s debt ratio might have been 0.3 last year. The industry average is 0.8, and the company’s main competitor has a debt ratio of 0.9. More information is derived by comparing gearing ratios to each other. A company with a 0.3 ratio is performing comparatively well in its industry when the industry average ratio result is 0.8, and the competition’s gearing ratio result is 0.9.

The Bottom Line

Gearing ratios are financial metrics that compare a company’s equity to its debt in several ways. They assess a company’s leverage and financial stability. Comparing a company’s gearing ratio with that of other companies in the same industry, it provides more information and a greater understanding of the business’s financial health.

Gearing ratios are useful for both internal management and outsiders, like financial institutions. The reasons include analyzing cash flows, assessing leverage, and deciding whether to issue loans.

Four types of gearing ratios are the debt (total debt divided by total assets), debt-to-equity (total debt divided by total equity), equity (equity divided by assets), and times interest earned (earnings before interest and taxes divided by total interest) ratios. Each plays a role in assessing a company’s financial condition.

A high gearing ratio can indicate increased risk, but doesn’t necessarily indicate poor financial health. Monopolistic firms or regulated industries are examples where higher ratios might be acceptable.

To make informed financial decisions, it’s important to view gearing ratios in the context of economic conditions and industry standards.