Gearing Ratio

Gearing ratio is a financial metric used to measure a company's level of financial leverage. It is a key financial indicator that shows the proportion of a company's debt to its equity capital. The ratio indicates the extent to which a company's operations are financed through debt or equity. The gearing ratio helps investors and analysts understand a company's financial health and ability to meet its financial obligations. This ratio is commonly used by lenders and investors to assess the creditworthiness of a company, as well as its ability to repay debt in the future. In this sense, the gearing ratio plays an important role in determining a company's creditworthiness and overall financial stability.

The gearing ratio is an important financial measure that provides insights into the amount of financial leverage a company has. It is an important part of financial analysis, which measures a business’s borrowed funds to equity. By calculating the gearing ratio, companies, analysts, and investors can learn how much the business’s operations depend on equity or debt. It reflects on the firm’s financial health. The gearing ratio is most commonly employed by investors and creditors to check a company’s creditworthiness and propensity to repay future debts.
 

In this article, we will explain the meaning of the gearing ratio, its uses among different sections of market participants, calculation, and risk mitigation measures. Let us begin by discussing the gearing ratio.

As the gearing ratio measures the financial leverage of a company, it is also called the leverage ratio. It indicates how solvent a company could be in the long run by analysing debt and equity financing. The gearing ratio is expressed as a ratio or percentage. Simply put, it is used to measure the borrowed funds of a company in proportion to its equity capital.
 

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The simple process of understanding the gearing ratio value is one of the reasons that makes it popular. If the gearing ratio of a company is high, it indicates a heavy reliance on borrowed funds for operations. On the flip side, a low leverage ratio indicates a higher utilisation of equity capital. Typically, the ideal level is in the moderate zone as a fine balance between debt and equity financing.
 

The leverage ratio is closely tracked by lenders and investors to analyse a company’s financials and ability to generate returns in the long run.

With the meaning of gearing ratio clear, let us now understand how it is commonly used:

• By lenders
  For creditors, the leverage ratio is a crucial metric that helps them understand the creditworthiness of companies. Companies that have high leverage ratios are risky and may find it difficult to secure favourable loans or financing, and vice versa.
• By investors
  The leverage ratio is important for analysts and investors to understand how risky an investment in a company could be as the metric reflects a company’s ability to manage debt and risk.
• Comparison
  Gearing ratios are important for analysts to compare and understand businesses within a sector. This can help determine the position of a company compared to its competitors.
• Capital structure planning
  The leverage ratio is important for businesses as well. It helps them understand and plan the structure of capital usage within the company and make decisions about future financing, according to its risk appetite.

The gearing ratio can be calculated with the formula below:
 

Gearing ratio = ((Short–term debt + Long–term debt + Overdrafts))/(Shareholders' equity capital)
 

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The debt-to-equity ratio is the most prevalent gearing ratio used in financial analysis. It compares a business’s cumulative debt to its shareholders' equity, indicating the extent to which the company is financing its operations through debt compared to wholly-owned funds. A high leverage ratio suggests a higher level of leverage and potential risk due to reliance on borrowed funds. On the other hand, a lower ratio indicates less dependence on debt and higher financial stability.

Let us understand the concept of gearing ratio with an example.
 

Suppose company A has a leverage ratio of 0.7. This indicates that the business is more reliant on debt compared to equity. To get a clearer picture, it is also important to examine the general gearing ratio of the industry.
 

On the other end of the world, company B has a gearing ratio of 0.4. While this seems fair even at first glance, upon closer examination it is revealed that the sector average is 0.7 and the company’s main rival stands at a leverage ratio of 0.8. This information further adds to the assessment and helps determine how well company ‘B’ is actually performing in its industry.

The ideal gearing ratio can vary significantly by industry, financial goals of businesses, and the stage that a company is at. Typically, a ratio over 50% indicates high debt relative to equity, and significant risk coupled with potential cash flow problems. Ratios between 25% and 50% are ideal for established businesses with stable cash flows and robust credit ratings, facing lower risks of defaults. Ratios under 25% are considered low-risk, indicating lower dependency on borrowing and robust income.
 

It is also important to note that extremely low leverage ratios may indicate missed growth opportunities owing to under-leveraging.
 

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The gearing ratio indicates a company's financial risk level. A high leverage ratio indicates more debt relative to equity, making the company highly vulnerable to interest rate changes and economic fluctuations, signalling higher financial risk. Conversely, a low gearing ratio suggests less debt and lower financial risk.

There are several ways in which businesses can reduce their leverage ratio. Some common strategies include:

• Paying off debt
  Perhaps the simplest, but the most effective, way is to pay off debts from profits to reduce the amount of liabilities.
• Issuing equity
  To reduce reliance on borrowed funds, another strategy could be to raise more equity capital by issuing new shares.
• Asset sales
  Businesses can also sell non-essential assets to pay off debts.
• Refinancing
  As a business, having the debt refinanced to benefit from better repayment terms and lower interest rates can also lower the gearing ratio.
• Reducing costs
  Lastly, cutting down on expenses like overhead costs or capital expenditures can enhance the cash flow and help pay off existing debts.

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The gearing ratio is a vital financial metric that helps assess a company's leverage and financial risk. By analysing this ratio, relevant stakeholders can make informed decisions about lending, investing, and managing company finances. Understanding and managing the gearing ratio is essential for maintaining financial stability and achieving long-term business success.