When measuring your organization’s financial health and solvency, there are numerous ways to slice and dice your fiscal data. Each type of financial analysis provides a piece of the puzzle, enabling you to better understand performance, inform stakeholders, and make decisions to drive your business forward.
One of the most popular sets of metrics used by financial institutions is gearing ratios. By using various gearing ratio formulas, you can discover what percentage of your operations is funded using shareholder equity vs the percentage that is funded using debt. This guide will explore everything you need to know about gearing ratios including multiple practical examples to follow along with.
What Is a Gearing Ratio?
A gearing ratio is a financial metric that compares your company’s debt level to its equity, providing insights into its financial structure and risk level. It’s a measure of the company’s financial leverage, revealing the extent to which its operations are funded by debt versus shareholder equity. Common types of gearing ratios include the debt-to-equity ratio and the equity ratio.
Organizations in both the business-to-consumer (B2C) and business-to-business (B2B) verticals have to assess financial risk and guide debt financing decisions. Whereas some metrics are designed to compare your business to other organizations in the same industry, gearing ratios are intended to assess internal financial health.
Generally speaking, an optimal gearing ratio is between 25 and 50%. Such a range indicates that you are maintaining a healthy balance between shareholder equity financing and debt ratio.
A low gearing ratio is anything under 25%, and a high gearing ratio is anything over 50%. If your gearing ratio is high, it means you tend to pay for operational costs using loans. This means that you’ll be more susceptible to interest rate increases and economic downturns.
Conversely, a low gearing ratio indicates that you are over-reliant on stakeholder equity, which could cause friction among investors. The key is balance.
It’s important to note that optimal and reasonable gearing ratios can differ significantly between industries and sectors.
When Should I Use Gearing Ratios?
There are numerous instances when you should use gearing ratios. They are crucial for investors to evaluate the risk and stability of potential investments. With that in mind, you can present positive gearing ratios to prospective investors in order to drive home your value proposition during a fundraising campaign.
Gearing ratios are also important metrics to keep an eye on internally to ensure that your debt doesn’t get away from you. As you get ready for a new fiscal year, it’s important to calculate your gearing ratios and consider how they changed over the previous revenue cycle. If your numbers are outside of optimal ranges, you may need to proactively move them back toward the healthy center.
While gearing ratios are just one piece of the financial puzzle, they provide essential context when compared to other financial metrics, like liquidity ratios, solvency ratios, or profitability margins.
Keep in mind that your company isn’t the only entity that will examine your gearing ratios. For instance, financial institutions often use gearing ratios when evaluating your loanworthiness. Some loan agreements may require you to operate within specific guidelines regarding gearing ratio calculations.
How to Calculate Gearing Ratios: The Formulas You Need
The most common gearing ratio formula determines the debt-to-equity ratio by dividing the company’s debt by its shareholders’ equity. The formula appears as follows:
The other approach involves calculating your simple equity ratio. To calculate the gearing ratio in this way, you’ll need to divide shareholder equity by company assets. The formula appears as follows:
These formulas can be calculated manually or using various financial tools and resources, like spreadsheet software or a financial analysis platform.
Finally, the third gearing ratio is the total-debt-to-total-assets-ratio. All you need to do for this ratio is to divide total debt by total assets. The formula appears as follows:
Interpreting Gearing Ratios: Analyzing Your Results
Once you’ve calculated your gearing ratios, it’s time to make sense of the numbers. Typically, a high gearing ratio indicates a lot of leverage. However, it doesn’t necessarily mean that your company is in poor financial health. Instead, it indicates that you have a riskier financial structure, as you’ve financed many of your operations using debt.
Generally speaking, two categories of businesses can operate with higher gearing ratios. If you operate in a tightly regulated vertical, you can usually operate with a bit more debt than a business that is in a loosely regulated industry. Additionally, there are some business models that just rely on sustaining large debts, like in the real estate sector.
Additionally, if your organization operates in a sector with little competition, it could be less susceptible to the risks of economic downturns and rising interest rates.
If you aren’t in one of these sectors, then it’s always best to have a lower gearing ratio, right? Not necessarily. A low gearing ratio indicates that you are less dependent on debt and, therefore, more resilient during economic turbulence and rising interest rates. However, maintaining that low gearing ratio comes at a cost — usually missed growth opportunities.
Taking on debt provides an injection of cash that you can use to support expansion efforts, hire more staff, upgrade equipment, or seize other emerging market opportunities. If you are relying primarily on stakeholder equity funding, you will likely enjoy less flexibility when these fleeting chances to grow emerge.
Applying Gearing Ratios: Practical Examples
Businesses use gearing ratios to make informed decisions about capital structure and financing. For instance, a company considering expansion might use its gearing ratio to determine whether to finance the expansion through debt or equity. A lower gearing ratio might encourage taking on more debt, leveraging the opportunity to grow while keeping financial risks manageable.
Consider how an identical gearing ratio means different things for unique businesses. In this scenario, company A is in the manufacturing sector and has a gearing ratio of 60%. This might be normal for its industry, where heavy investment in machinery is required.
In contrast, company B, a tech start-up with the same ratio, might be at higher risk due to its unpredictable revenue streams and the volatile nature of the industry.
From an investor’s perspective, allocating funds to the manufacturing entity might not appear overly risky, as a 60% gearing ratio is “normal.” Conversely, investing in company B carries a high degree of risk.
Different sectors exhibit typical gearing ratios reflective of their operational needs. In industries like manufacturing, utilities, real estate, or telecommunications, higher gearing ratios are common due to the significant capital expenditures required. Furthermore, companies in these verticals often have a monopolistic foothold on the market. For example, consumers typically have a choice of only a few telecom providers based on where they live.
Gearing ratios also have a strong correlation with cash flow. One study of 36 manufacturing firms discovered that a high capital gearing ratio has a negative effect on cash flow.
Researchers also discovered a negative correlation between a high-income gearing ratio and cash flow and a positive correlation between a high-operating gearing ratio and cash flow. However, these two correlations were non-significant.
Gearing Ratios: A Guide for Investors
If you are evaluating investment opportunities, it is vital to consider the gearing ratio during your due diligence period. While the 25 to 50% optimal gearing ratio threshold provides a good starting point for your evaluation process, you can’t examine these figures in a vacuum.
Businesses that are monopolistic in nature or required to invest in costly fixed assets can be viable investment opportunities, even if they fall slightly above the normal range. Conversely, volatile start-ups may be less appealing investments despite staying under the 50% gearing ratio threshold.
When examining the viability and financial risk associated with an investment opportunity, consider how the company’s ratio compares with industry standards. Also, consider ratios across different verticals so you can obtain a holistic view of your risk profile.
Limitations of Gearing Ratios: What to Watch Out For
Like all financial metrics, gearing ratios provide only a fragment of the puzzle. They can also be misleading if you over-rely on them to the point that you ignore or partially disregard other metrics.
One potential issue is ratio misinterpretation. For instance, suppose that a utility company has a 55% gearing ratio. Since this figure falls outside of the “optimal” threshold, you immediately deem the investment too risky. However, had you dug deeper, you would have discovered that the company’s gearing ratio is well within the normal range for its vertical.
Another shortcoming of gearing ratios is that the calculations are based on historical data. Therefore, they may not fully capture future uncertainties or the company’s current cash flow dynamics. Recent moves, such as new loans or debts, may not be reflected in ratios.
Additionally, economic downturns can significantly impact gearing ratios. A company with a high ratio might struggle during a recession, as decreased revenue makes it challenging to service debt. The recession could impede your return or result in a loss of equity. Other factors that could make gearing ratios unreliable include:
- Old or inaccurate data
- Failure to include other metrics in your decision
- A lack of industry-specific context
Balancing gearing ratios with other financial indicators, such as liquidity ratios, profitability margins, and cash flow statements, provides a more comprehensive view of a company’s financial health. This holistic approach enables better-informed decisions and a clearer understanding of the company’s financial position.
Understand Your Company’s Financial Leverage With Gearing Ratios
Gearing ratios provide a valuable glimpse into a company’s financial leverage. While the debt-to-equity ratio is the most common, it is important to consider several variations when assessing financial risk. For instance, comparing debt and equity gearing ratios to the standard debt-to-equity ratio will provide more granular insights into a company’s financial performance.
As an organizational decision-maker, tracking gearing ratio trends will help you understand how to approach new growth opportunities and cover operational expenses. If you are an investor, use these data points to balance your portfolio and stay within acceptable risk tolerances.
Moving forward, apply these concepts to your financial analytics processes so you can obtain a more complete picture of risk and business performance. Remember, the power of financial analysis lies in its application.