Gearing Ratio: Complete Guide with Examples
In this guide, we'll dive deeper into the gearing ratio, explain how to calculate and interpret it, examine its benefits and drawbacks, and provide you with examples to make it easier to apply this instrument to your analysis.
What Is a Gearing Ratio, and What Does it Tell Investors?
A gearing ratio is a calculation used to show the degree of a company's financial leverage. It is found by dividing total credit funds by shareholder's equity. This number tells how much debt the company uses compared to the money investors have put into the business. As such, a low gearing ratio implies that the company can pay its debt several times over, while high gearing represents a highly leveraged business that is likely to face more risk during times of market volatility.
High Gearing Ratio vs Low Gearing Ratio: How to Interpret Ratio
It's difficult to say whether a company has a good gearing ratio or a bad one. Everything's relative. When conducting such an analysis, it's crucial to take into account the total market situation and make a comparison between a particular business you want to invest your capital in and other companies from the same industry. However, there are some commonly used gearing ratio measures: low, middle and high. Let's have a closer look at them.
- A low gearing ratio is below 25%. This means that a company uses less debt financing and more equity financing. Both investors and lenders would consider this ratio to be low-risk because, if the asset goes down in value, the equity will cushion the loss.
- Mid-level or optimal gearing ratio is between 25% and 50%. Companies with this level of gearing are usually characterised as stable, well-established and with a reasonable level of risk.
- High gearing ratio is more than 50%. A company with high gearing is said to be more leveraged. This means that investors have to deal with an increased risk of losing money. This is because the company's debt holders have the first claim on its assets and profits. If it comes to liquidation, the shareholders will only receive any proceeds after the creditors have been paid in full.
Gearing Ratio Formulas
There are several ways to calculate gearing ratio. However, the most common gearing ratio formula is:
|NET Gearing Ratio= (Long-term debt + Short-term debt + Bank overdraft) / Shareholder's equity|
Another common gearing calculation is based on the debt-to-equity ratio. All you need to do is divide the total company debt by the total amount of company equity. The formula will be as follows:
|Company's gearing ratio = Total debt / Total equity|
The gearing ratio can also be presented in percentages. It's necessary to multiply the result from the formula above by 100:
|Company's gearing ratio = (Total debt / Total equity)*100|
The debt ratio is very similar to the debt-to-equity ratio. It shows the percentage of a company's assets that are financed by debt and is calculated by dividing total liabilities by total assets.
|Debt ratio = Total debt / Total assets|
The equity ratio is a financial ratio that measures the extent to which the equity capital of a company is owned by its stockholders. It is calculated by dividing a company's total equity by its total assets.
|Equity ratio = Total equity / Total assets|
How to Calculate the Gearing Ratio of the Company You Are Researching
Once you decide to calculate the gearing ratio of a particular company, here are the steps to follow:
- Choose the company. As a result, the gearing ratio will help you analyse if it is a potentially good investment option.
- Choose the most suitable gearing ratio formula. There are various ways to calculate gearing ratio; one of the most commonly used is the debt-to-equity ratio.
- Calculate the gearing ratio. If you've chosen the debt-to-equity calculation method, it's necessary to divide the total debt of the company by its total equity. If you want to receive the result in percentage, multiply the fraction by 100.
- Analyse the results. Companies with high gearing ratios are considered risky, as they have considerable debt that must be paid back. Low gearing ratios indicate that the company is more conservative, stable and associated with lower risks.
Example of a Gearing Ratio and Its Interpretation
Here is an example of how to calculate and interpret the gearing ratio. Let's say that an imaginary company — we'll call it AAA — has a total debt of $1 million, while its total equity accounts for $4 million. To calculate its gearing ratio using the debt-to-equity formula, we need to divide total debt by total equity and, if we want to have the result in percentage, multiply the result by 100.
|AAA's gearing ratio = ($1 million / $4 million)*100 = 25%|
25% is a good gearing ratio, meaning that the company has a higher percentage of financing that comes from equity. This business is likely to be more financially stable and less risky, especially if the investment does not perform as well as expected.
Let's have a look at an opposite example. Company AAA has come with the following financials:
- Total debt - $4 million
- Total equity - $2 million
Then, the calculation of the gearing ratio will look like this:
AAA's gearing ratio = ($4 million / $2 million)*100 = 200%
This is an extremely high result, which means that for each $1 of equity, the company has $2 in debt. In this situation, the company AAA will be significantly riskier to invest in.
Gearing Ratio and Risk: Everything You Need to Know
Gearing ratios are often used to evaluate a company's financial health, as well as its level of risk for potential investors and lenders. Businesses with high gearing ratios are considered riskier than those with low ratios, as they have more debt that must be paid back. In addition, companies with high gearing may find it difficult to obtain new financing, as lenders will view them as being less financially stable. As a result, this can put them at risk of defaulting on their loans or going bankrupt.
However, it's important to note that not all companies with high gearing ratios are financially unstable. Some of them may have such a percentage because they are operating in industries with high levels of debt, such as the oil and gas industry. In these cases, the higher gearing ratio may actually be due to factors beyond the company's control.
The gearing ratio is a robust tool that is helpful when trading any financial assets. However, it's particularly useful for potentially riskier instruments like CFDs.
CFDs are very popular in the modern world of online trading. This is because they offer many advantages, such as low transaction costs, high leverage and the ability to trade on a wide range of assets. For CFD traders, it is important to understand the gearing ratios of the companies they are trading, as this will help them to mitigate the potential risks.
How Can Companies Reduce Their Gearing?
Gearing can be reduced if the company starts to pay off its liabilities. Several techniques can help businesses to control and improve their gearing ratio. Here are some of them:
- Reduce reliance on debt financing. A company may need to take on new investors, sell assets, or restructure its business. This strategy can be difficult to implement, but it can ultimately help a company protect its financial stability.
- Raise new equity capital by selling shares. This will help to generate cash that can be used to reduce debt.
- Increase profits. By increasing profits, the company will be able to collect money to pay off its existing debts and increase the price of its stock.
- Reduce operational costs. This can be accomplished through a variety of methods, such as reducing the number of employees, lowering salaries or cutting other expenses. While such measures may seem drastic, they can be necessary to keep the company afloat during difficult economic times.
Pros and Cons of Gearing Ratios
A gearing ratio is a handy tool for investors and lenders that helps them make more consistent decisions. However, just as with any tool, this indicator comes with its benefits and drawbacks.
The major advantage of gearing ratios is that they provide a quick and easy way to assess a company's leverage. For example, a high ratio may indicate that a company is highly leveraged and thus riskier. On the other hand, a low gearing may denote that a company has a strong financial position and is less likely to default on its debts.
When it comes to the disadvantages of using this ratio, one challenge is that different companies use different accounting methods, which can make comparisons difficult. Additionally, gearing ratios do not take into account important factors such as the interest rate on a company's debt or the maturity date of its debt obligations. Moreover, as mentioned before, it's necessary to understand that high gearing doesn't always indicate financial instability, especially for companies operating in high-risk industries.
Summing up, a gearing ratio is a powerful tool. However, it should be used in combination with other tools in an overall assessment of a company's financial health rather than as the sole indicator.
What is a good gearing ratio?
The concept of a good or bad gearing ratio is rather relative. Much depends on the industry the company is operating in and its individual circumstances. In general, a high gearing ratio (more than 50%) indicates that a company is more leveraged and, therefore, has more risk. A low ratio (less than 25%) indicates that a company is less leveraged and, therefore, is considered less risky.
Is a high gearing ratio good or bad?
Every company has to decide for itself. It depends on various factors, such as the industry in which it operates, the level of risk that it is willing to take on, and more. A higher gearing ratio is considered to be more aggressive and riskier. As such, it is often associated with faster growth, as well.
Is the gearing ratio the same as the debt ratio?
The gearing and debt ratios are two different financial ratios used to assess a company's financial health. The gearing ratio measures the proportion of a company's debt to its equity, while the debt ratio is based on the proportion of a company's assets financed by debt. The gearing ratio is focused on a company's capital structure, while the debt ratio includes all forms of debt, not just equity.
What are examples of gearing ratios?
There are several types of gearing ratios. The debt-to-equity ratio is the most common of them. It is calculated by dividing a company's total debt by its total equity. A high debt-to-equity ratio means that a company is highly leveraged and may be at risk of a financial downturn. Some other types of gearing include debt-to-asset ratio and equity multiplier.
What is the importance of gearing ratios?
Gearing ratios are powerful tools for analysing a company's financial health and assessing its riskiness as an investment. The most common gearing ratio is the debt-to-equity ratio, which compares a company's total debt to its equity. However, it's important to remember that just as any indicator, it has its pros and cons. As such, it's better to implement it in compliance with other tools to assess a company's financial stability.
Disclaimer: The information in this article is not intended to be and does not constitute investment advice or any other form of advice or recommendation of any sort offered or endorsed by Libertex. Past performance does not guarantee future results.
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