Gearing ratios provide insight into how a company finances its operations, relative to debt and equity.

Using gearing ratios is part of your fundamental trading analysis strategy and helps provide important financial ratios with which to make smarter trading decisions.

Continue reading this article to learn about what gearing ratios are and how they can support the best decision-making in your business.

**Table Of Contents**

**1** What is the Gearing Ratio?

**2** Gearing Ratio and Risk

**3** Formulas for Calculating Gearing Ratio

**3.1** Debt to equity ratio

**3.2** Loan ratio

**3.3** Equity ratio

**4** Ways to Calculate Gearing Ratio

**4.1** Example of calculating gearing ratio

**5** High VS Low Gearing Ratio

**6** Who Uses the Gearing Ratio?

**6.1** Lenders

**6.2** investors

**6.3** Comparison tool

**7** Tips to Control Gearing Ratio

**7.1** Debt management

**7.2** Increase profits

**7.3** Reduce costs

**What is Gearing Ratio?**

Gearing ratios are a popular group of financial ratios that compare a company’s debt to other financial metrics such as business equity or company assets. According To Steve Lobsey The Gearing Ratio (Debt: Equity Ratio)

This ratio represents a measure of financial leverage that determines the extent to which a company’s actions are funded by shareholder equity compared to creditor funds.

Gearing ratios can be a useful part of fundamental analysis. The calculation of this ratio also helps provide clarity about the sources of funding for the company’s operations, which provides greater insight into the reliability of the companies and whether they are able to survive periods of financial instability.

There are several ratios that compare owner’s equity to the funds borrowed by the company. Gearing ratio measures the level of the company’s financial risk. The most famous ratios include:

- Debt to equity ratio
- Equity Ratio
- Debt to equity ratio
- Debt service ratio (
*Debt service ratio*) - Debt to shareholder funds ratio

When a company has a high gearing ratio, this indicates that the company’s leverage is high. Thus, it is more vulnerable to any possible downturn in the economy. Companies with low gearing ratios are generally considered to be more financially healthy.

**Gearing Ratio and Risk**

The level of gearing, whether low or high, reveals the level of financial risk facing the company. Highly geared companies are more vulnerable to economic downturns and face a greater risk of default and financial failure.

This means that with limited cash flow obtained by the company, it must meet its operational costs and make debt payments. A company may experience frequent cash flow shortages and fail to pay shareholders’ and creditors’ equity.

A low gearing ratio does not necessarily mean that the capital structure of the business is healthy. Capital-intensive firms and highly cyclical firms may not be able to finance their operations from shareholder equity alone.

At some point, they will need to get financing from other sources to continue operations. Without debt financing, a business may not be able to fund most of its operations and pay internal costs.

Businesses that don’t use debt capital lose out on cheaper forms of capital, increased profits, and more investor interest.

For example, firms in the agricultural industry are affected by seasonal demand for their products. Therefore, they often need to borrow funds at least for the short term.

**The formula for Calculating Gearing Ratio**

Each gearing ratio formula is calculated differently, but most formulas include a company’s total debt as measured against variables such as equity and assets.

**Debt to equity ratio**

Perhaps the most common method of calculating a business’s gearing ratio is to use a debt-to-equity measure. Simply put, it is the debt of the business divided by the equity of the company.

**Debt to equity ratio = total debt total equity**

The debt-to-equity ratio can be converted to a percentage by multiplying a fraction by 100. This is probably an easier way to understand corporate gearing and is generally common practice.

(Percentage of debt to equity / total debt to total equity) × 100

**Loan ratio**

The debt or loan ratio is very similar to the debt to equity ratio, but alternatively, it measures total debt to total assets. This ratio provides a measure of the extent to which a business’s assets are financed by debt.

Debt ratio = total debt total assets

**Equity Ratio**

In contrast, the equity ratio provides a measure of how financed a company’s assets are with shareholder investment. In contrast to other gearing ratios, a higher percentage is often better.

Equity ratio = total equity total assets

**How to Calculate Gearing Ratio**

Gearing ratios can be calculated to give an indication of how well the business is performing. To calculate the debt-to-equity ratio, you must divide the company’s total debt by the total equity. In most gearing ratios, the higher the percentage ratio , the more risk associated with business operations.

**Example of calculating gearing ratio**

Let’s say company ABC has the following finances:

- Total Debt: 100,000
- Total Equity: 400,000

The debt-to-equity ratio of company ABC can be calculated by taking total debt divided by total equity, then taking the ratio and multiplying by 100 to express the ratio as a percentage.

( 100,000 /400,000 ( × 100 ) ) = 25% debt to equity ratio

**High VS Low Gearing Ratio**

As noted above, when measuring the quality of a company’s gearing ratio, it is recommended that you measure against competitors in the same industry as they can vary widely across industries. Below are some basic guidelines for analyzing high and low gearing ratios:

**Gearing ratio that exceeds 50%.**A gearing ratio that exceeds this number will represent a company that really needs to be improved. Companies will be more at risk during times of financial instability, as debt financing will increase business risk during economic downturns or interest rate spikes.**Medium level gearing ratio between 25% and 50%.**Mid-level gearing ratios are known to be normal for an established company.**Gearing ratio is low below 25%. Investors,**lenders and any other party analyzing financial documents would view a gearing ratio below 25% as very low risk.

**Who Uses Gearing Ratio?**

**Lenders**

Lenders use the gearing ratio to determine whether or not to extend credit. They are in the business of generating interest income by lending money.

Lenders consider the gearing ratio to help determine the borrower’s ability to repay the loan.

For example, startups with a high gearing ratio face a higher risk of failure. Most lenders would prefer to stay away from these clients. However, monopolies such as utilities and energy companies can often operate safely with high levels of debt, because of their strong industrial position.

**investor**

Investors use gearing ratios to determine whether a business is a worthy investment. Companies with strong balance sheets and low gearing ratios are easier to attract investors. Investors may view companies with high gearing ratios as too risky.

A well-prepared company has already paid high-interest rates to its lenders and new investors may be reluctant to invest their money, because the business may not be able to repay the money.

**Comparison tool**

The gearing ratio is used as a comparison tool to determine the performance of one company vs. another company in the same industry. When used as a standalone calculation, a company’s gearing ratio may not mean much.

Comparing these ratios from similar companies in the same industry provides more meaningful data. For example, a company with a gearing ratio of 60% could be considered high risk. But if its main competitor exhibits a gearing ratio of 70%, compared to the industry average of 80%, the company with the ratio of 60%, by comparison, performs optimally.

**Tips for Controlling Gearing Ratio**

There are several ways that companies can try to indirectly manage and control the gearing ratio, usually with earnings, debt, and expense management.

**Debt management**

Perhaps the easiest is debt management. If a company manages its debt efficiently, they should be able to reduce their gearing ratio.

Companies can take steps to pay off their debts and thus, incur less interest in the long run.

Companies can also take advantage of debt management schemes to avoid taking out more loans. In addition, companies should seek to renegotiate debt terms in an effort to reduce long-term liabilities.

**Increase profits**

Increasing profits will help increase the share price and thus, shareholder equity. On the other hand, sometimes taking out a loan, in which case it can help the business become more profitable in the long run.

**Reduce costs**

Reducing costs will reduce liabilities and therefore increase the gearing ratio. Reducing costs can include anything from renegotiating loan terms, improving business efficiency, and introducing basic cost controls.