A gearing ratio gives useful insight into a company’s structure and level of risk. It’s used by investors, analysts, and lenders alike to draw conclusions about the company’s ability to fund its operations using things like equity and debt. Here’s a closer look at common gearing ratios and how they work.
What is a gearing ratio?
There’s no singular formula to determine ‘what is a gearing ratio’. This term describes a full category of financial ratios used to compare company debt to various financial metrics, such as assets and equity. Gearing ratios are part of a wider analysis strategy, providing insight that helps investors make smarter decisions. For example, by looking at the ratio of shareholder equity to creditor funds, you can learn more about its operations, risk, and financing.
What gearing ratios have in common is that they’re primarily focused on leverage, which is why they’re also called leverage ratios. Lenders might use these to decide whether to extend credit, while investors use financial leverage ratios to decide whether to make an investment. In general, the higher the gearing ratio, the higher the financial risk.
Top gearing ratio formulas
There are several different gearing ratio formulas, each calculated differently. Most offer up some combination of total debts vs a variable like company assets. Here are some of the most popular gearing ratio formulas:
1. Debt-to-equity ratio
The most popular leverage ratio measures debt to equity. This is expressed using the following formula:
Total Debt / Total Equity
You can then convert this into a percentage by multiplying the result by 100.
2. Debt ratio
Another common option is the debt ratio, but this measures debt against assets rather than equity:
Total Debt / Total Assets
Again, you can multiply the result by 100 to reach a percentage for analysis. The debt ratio gives you a quick indicator of how many of the business’s assets are paid for using debt.
3. Equity ratio
A third financial leverage ratio is the equity ratio, which swaps in equity for debt:
Total Equity / Total Assets
With leverage ratios that include debt, it’s better to have a lower ratio in terms of risk. This is reversed with the equity ratio, because higher percentages indicate that more of the company’s assets are financed with equity rather than debt.
What do leverage ratios mean?
Whichever formula you choose, leverage ratios like the examples above give you some idea of how well a company will be able to meet its financial obligations during normal economic fluctuations.
When gearing ratios show that companies have higher debt in relation to equity, it indicates that they may take on more liabilities than they’re able to comfortably pay. This is why lenders will often use leverage ratio calculators to make decisions about loan applications. Internally, companies might use gearing ratio as part of cash flow analysis.
While the definition of a high or low gearing ratio depends on a company or investor’s financial goals, here are some basic guidelines:
Gearing ratio above 50%: indicates that the company is at risk during times of financial instability
Gearing ratio between 25% and 50%: indicates that the company could comfortably manage risk
Gearing ratio below 25%: Indicates that the company has little debt and is very low risk for investors
How to manage leverage ratios
If you’re a business owner trying to manage your leverage ratios, here are a few techniques to get them to a lower level.
Manage your debts more efficiently, paying off long-term debt to reduce interest payments.
Consolidate debts into a single repayment plan for easier management.
Find ways to increase profits and boost shareholder equity as a result.
Reduce everyday expenses through cost cuts and efficient upgrades to processes.
By looking at your own gearing ratios, you can find ways to make your business more likely to both attract investor interest and weather financial storms.
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