What is a Gearing Ratio?

A gearing ratio shows how much a company relies on borrowed money (debt) compared to its own money (equity). It helps investors understand how financially stable a company is.

In simple terms, it tells you how much of the company's operations are paid for using loans instead of the company’s funds.

If the gearing ratio is high, it means the company has a lot of debt compared to what it owns. This could be a sign of risk, but it depends on the type of business.

Gear Ratio Definition

The gearing ratio is a financial metric that compares a company's debt to its equity. It indicates the degree to which a company is financed by debt versus its funds. A higher ratio suggests higher financial risk, as the company relies more on borrowing. 

What is the Formula of Gearing Ratio?

The most common way to figure out a company’s gearing ratio is by using the debt-to-equity ratio. This means you compare how much debt the company has to how much money the owners (shareholders) have put into the business.

To find the owners’ equity, you subtract what the company owes (liabilities) from what it owns (assets).

The formula for the gearing ratio is:

Net Gearing Ratio = long-term debt + short-term debt + bank overdraft/shareholder equity

This ratio is shown as a percentage. It tells you how much of the company’s equity would be needed to pay off all its debt. 

How to calculate the Gearing Ratio?

Let us say a company owes $2 billion and has $1 billion in shareholder equity. That means its gearing ratio is 2, or 200%. In simple terms, for every $1 the investor has put into the company, it has borrowed $2. This is a very high level of debt and would be seen as risky.

What are the types of gearing ratios?

Below are the types of gearing ratios:

Debt-to-Equity Ratio

• The debt-to-equity ratio (D/E ratio) is a key financial metric used to evaluate a company’s financial leverage by comparing its total liabilities to shareholder equity. This ratio provides insight into the extent to which a company is financing its operations through debt versus wholly owned funds.
   
• Calculated by dividing total liabilities by shareholder equity, the D/E ratio helps investors, creditors, and financial analysts assess a company’s capital structure and risk profile.
   
• A higher D/E ratio suggests that a company relies more heavily on borrowed funds to finance its operations, which may indicate higher financial risk. Conversely, a lower D/E ratio implies the company is funding its activities primarily through equity, signaling a more conservative financial strategy.
   

Debt Ratio

• An alternative method for assessing a company’s financial leverage is through the analysis of its debt ratio. This ratio represents the proportion of a company’s total debt relative to its total assets.
   
• The debt ratio can be expressed either as a decimal or a percentage. A ratio exceeding 1.0 (or 100%) indicates that the company has more liabilities than assets, suggesting a higher reliance on debt financing. 
   
• Conversely, a ratio below 1.0 (or 100%) indicates that a larger portion of the company’s operations is financed through equity.
   
• A debt ratio of 30% may be deemed excessive in industries where companies typically maintain low levels of debt. 

 Equity Ratio

• The equity ratio is a key gearing ratio used to assess a company’s financial leverage. It compares total equity to total assets, providing insight into the extent to which a company is financed by shareholders versus creditors.
   
• Expressed as a decimal, an equity ratio of 0.50 or lower typically indicates higher leverage, meaning the company relies more heavily on debt financing.
   
• Conversely, a higher equity ratio suggests lower financial leverage, indicating that the company is primarily funded through equity.
   
• A strong equity ratio reflects sound financial health and enhances a company’s appeal to investors and lenders, as it suggests a greater ability to meet debt obligations. 

What is a good and bad gearing ratio?

Whether a gearing ratio is good or bad depends on the industry and what other similar companies are doing. But there are some general rules:
 

• A high gearing ratio is over 50%
• A low gearing ratio is under 25%
• An ideal gearing ratio is between 25% and 50%

If a company has a high gearing ratio, it means it relies a lot on borrowed money (loans) to run its business. This can be risky, especially if the economy gets worse or interest rates go up. In serious cases, it could lead to money problems or even bankruptcy.

If a company has a low gearing ratio, it usually spends more carefully or works in an industry that’s affected by the economy. To avoid taking on too much debt, these companies use money from shareholders (called equity) to cover big expenses.

How Can Companies Reduce Their Gearing Ratio?

Companies can lower their gearing ratio (the amount of debt compared to their own money) by paying off their debts. Below are some ways they can do that:

Sell more shares: They can offer more shares to the public. The money they get from selling shares can be used to pay off debt.

Turn loans into shares: They can make deals with lenders to change some of the loans into shares. This means the lender becomes a part-owner instead of being owed money.

Cut costs: By spending less and finding ways to work more efficiently, the company can save money and use it to pay off debts.

Make more profit: By improving their business and making more money, they can use the extra profit to reduce their debt.

What are the factors influencing gearing ratios?

Many different business factors can affect a company’s gearing ratio, which shows how much of the company’s financing comes from debt compared to equity (ownership).

If a company follows a bold or aggressive business strategy, it might take on more debt. This isn’t always bad—it depends on other things like how much equity or assets the company has.

There are also ways a business can lower its gearing ratio, such as:
 

• Selling more shares
• Turning loans into shares
• Cutting down the amount of money tied up in day-to-day operations
• Increasing profits

Industry Differences

Companies in industries that need a lot of investment to operate—like utilities or telecommunications—often have higher gearing ratios because they need more capital to run.

Changes Over Time

Gearing ratios can change over time. A high ratio doesn’t always mean trouble—it might simply mean the company chose to borrow money when interest rates were low to grow or invest.

Economic Conditions

The economy also plays a big role. If interest rates rise or the economy slows down, companies with a lot of debt may struggle. Having too much debt can be risky. On the other hand, things like a strong market position or future growth potential can help balance out the risks.

How Companies Use Their Money

Companies also make choices about where to invest or spend their money—this is called capital allocation. Smart decisions in this area can help a company manage or lower its gearing ratio and reduce financial risk. 

Pros and Cons of Gearing Ratios

Below is a table summarizing 6 pros and 6 cons of gearing ratios, which are financial metrics used to assess a company's financial leverage by comparing debt to equity or capital:
 

Conclusion

Gearing ratios show how much a company relies on borrowed money compared to the money invested by its owners (shareholders). It tells us how much of the company’s operations are funded through loans versus shareholders’ equity. This is important because it helps investors understand how financially stable a company is. If the gearing ratio is high, it means the company has a lot of debt, which can be risky.

If you are using a stock market trading app to research companies before investing, checking their gearing ratio can help you make smarter decisions.