What Are Gearing Ratios?

Gearing ratios are financial ratios that compare some form of owner's equity or capital to debt or 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 funded๊ by shareholders' funds versus creditors' funds.

The gearing ratio is a measure of financial leverage that demonstrates the degree to which a firm's operations are funded by equity capital versus debt financing.

Understanding Gearing Ratios

The best-known e🥂xa😼mples of gearing ratios include:

$\begin{aligned}&\text{Debt-to-Equity Ratio}=\frac{\text{Total Debt}}{\text{Total Equity}}\\\\&\text{Times Interest Earned}=\frac{\text{EBIT}}{\text{Total Interest}}\\\\&\text{Equity Ratio}=\frac{\text{Equity}}{\text{Assets}}\\\\&\text{Debt Ratio}=\frac{\text{Total Debt}}{\text{Total Assets}}\end{aligned}$​Debt-to-Equity Ratio=Total EquityTotal Debt​Times Interest Earned=Total InterestEBIT​Equity Ratio=AssetsEquity​Debt Ratio=Total AssetsTotal Debt​​

A higher gearing ratio indicates that a company has a higher degree of financial leverage. It's more susceptible to downturns in the economy and the 澳洲幸运5官方开奖结果体彩网:business cycle because companies that have higher leverage have higher amounts of debt compared to 澳洲幸运5官方开奖结果体彩网:shareholders' equity. Entities with a high gearing ratio have higher amounts of debt to service. Comꦐpanies with lower gearing ratio calculations have more equity to rely on for financing.

Gearing ratios are useful for both internal and external partie𝔉s. Financial institutions use gearing ratio calculations when they're deciding whether to issue loans. Loan agreements may also require companies to operate within specified guidelines regarding acceptable gearing ratio calculations. Internal management uses gearing ratios to analyze future cash flows and leverage.

Interpreting Gearing Ratios

A high gearing ratio typically indicates a high degree of leverage but this doesn't always indicate that a company is in poor financial condition. 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 because they can operate with higher levels of debt.

Companies in 澳洲幸运5官方开奖结果体彩网:monopolistic situations often operate with higher gearing ratios because their strategic marketing position puts them at a lower risk of default. Industries that use expensive fixed assets typically have higher gearing ratios because these 澳洲幸运5官方开奖结果体彩网:fixed assets are often financed with debt.

Example of How to Use Gearing Ratios

Assume that a company has a debt ratio of 0.6. This figure alone provides some information a༒s to the company’s financial structure but it's more meaningful to benchmark it against another company♓ in the same industry.

The company's debt ratio might have been 0.3 last year. The industry average is 0.8 and the company’s main competitor has a debt ratio of 0.9. More information is derived by comparing gearing ratios to each other. A company with a 0.3 ratio is performing comparatively well in its industry when the industry average ratio result is 0.8 and the competition's gearing ratio result is 0.9,

The Bottom Line

Gearing ratios compare a company’s equity to its debt. The result in𝐆dicates its financial leverage or how much of its operational debt is serviced via shareholders’ equity and/or borrowed funds. It’s a strong measure of financial stability and something an investor should keep an eye on. A high gearing ratio can raise a red flag and be risky.