Gearing Ratio

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Gearing Ratio

What is a gearing ratio?

Gearing ratios measure a company’s financial leverage by comparing debt to equity or other capital measures. They show how much of a firm’s operations and assets are financed with borrowed funds versus shareholders’ equity. Higher gearing means greater reliance on debt and typically higher financial risk.

Common gearing ratios and formulas

How to interpret gearing ratios

  • A higher gearing ratio indicates more leverage and greater exposure to interest costs and insolvency risk, especially during economic downturns.
  • A lower gearing ratio suggests more of the company is financed by owners’ equity, offering greater cushion against shocks.
  • “Good” or “acceptable” levels vary by industry: regulated utilities and capital-intensive firms often carry higher gearing; tech or service firms generally have lower gearing.
  • Always compare a company’s gearing to industry peers, historical trends, and company-specific factors (stability of cash flows, asset base, regulatory environment).

Example

If a company has a debt ratio of 0.6:
– That means 60% of assets are financed with debt.
– If last year’s ratio was 0.3, the company has significantly increased leverage.
– If the industry average is 0.8 and a main competitor is 0.9, the company is less leveraged than peers and may be in a relatively stronger position despite increasing leverage year over year.

Uses

  • Lenders and credit analysts use gearing ratios to assess creditworthiness and set loan covenants.
  • Management uses them to evaluate capital structure decisions, financing plans, and future cash flow risks.
  • Investors use gearing to gauge risk and the potential impact of interest rate changes on earnings.

Limitations

  • Ratios vary by accounting methods and balance-sheet presentation.
  • They don’t capture off-balance-sheet liabilities (e.g., operating leases unless capitalized).
  • A high gearing ratio isn’t automatically bad if the company has stable cash flows and strong earnings growth.
  • Ratios are most informative when compared across peers and over time.

How to improve gearing

  • Reduce debt (repay borrowings or refinance on longer terms).
  • Increase equity (new equity issuance, retained earnings).
  • Improve profitability and cash flow to raise interest coverage.

Key definitions

  • Shareholders’ equity: the residual interest in assets after liabilities (includes share capital, retained earnings, and other reserves).
  • EBIT: earnings before interest and taxes—used to assess operating ability to cover interest.
  • Financial leverage: the degree to which a company uses debt to finance assets; often measured as total assets divided by shareholders’ equity.

Bottom line

Gearing ratios are essential tools for assessing financial structure and leverage. They provide insight into risk from debt financing but must be interpreted in context—industry norms, company history, asset structure, and cash-flow stability all matter.