What is the ‘Gearing Ratio’
A gearing ratio is a general classification describing a financial ratio that compares some form of owner’s equity (or capital) to funds borrowed by the company. Gearing is a measurement of the entity’s financial leverage, which demonstrates the degree to which a firm’s activities are funded by owner’s funds versus creditor’s funds.
BREAKING DOWN ‘Gearing Ratio’
The best known examples of gearing ratios include the debt-to-equity ratio (total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and debt ratio (total debt / total assets).
Degree of Leverage
Higher calculations of a gearing ratio indicate a company has higher degree of leverage and is more susceptible to downturns in the economy and in the business cycle. This is because companies that have higher leverage have higher amounts of debt when compared to owner’s equity. Therefore, entities with high gearing ratio findings have higher amounts of debt to service. Companies with lower gearing ratio calculations have more equity to rely upon as financing is needed.
Gearing Ratio Evaluation
Gearing ratios are most beneficial to companies when used as a tool for comparison. As a standalone calculation, a gearing ratio may not hold any weight or meaning. For example, a company may have a debt ratio of 0.6. Although this figure alone provides some information as to the company’s financial structure, it is more meaningful to benchmark this figure against another. For instance, the company had a debt ratio last year of 0.3, the industry average is 0.8 and the company’s main competitor has a debt ratio of 0.9. More information is derived through the use of comparing gearing ratios to each other.
Users of Gearing Ratios
Gearing ratios are useful for both internal and external parties. Financial institutions utilize gearing ratio calculations in preparation of issuing loans. In addition, loan agreements may require companies to operate with specified guidelines regarding acceptable gearing ratio calculations. Alternatively, internal management utilizes gearing ratios to analyze future cash flows and leverage.
Gearing Ratio Tendencies
A high gearing ratio typically indicates a high degree of leverage. This does not indicate a company is in poor financial condition. Instead, 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, as they are able to operate with higher levels of debt. In addition, companies in monopolistic situations often operate with higher gearing ratios, as their strategic marketing position puts them at a lower risk of default. Finally, industries that utilize expensive fixed assets typically have higher gearing ratios, as these fixed assets typically are financed with debt.