The gearing ratio is a financial metric that measures a company’s financial leverage by comparing its debt to equity or total assets. It helps investors and analysts assess a company’s ability to meet its long-term financial obligations and manage risk.

Understanding Gearing Ratio

The gearing ratio indicates how much a company relies on borrowed funds to finance its operations. A high gearing ratio suggests greater financial risk due to high debt levels, while a low gearing ratio implies a more conservative approach with lower reliance on debt.

For example, if a company has a gearing ratio of 60%, it means that 60% of its capital structure is funded by debt, while the remaining 40% is financed by equity.

Types of Gearing Ratios

1. Debt-to-Equity Ratio – Measures total debt as a percentage of shareholder equity: Debt-to-Equity Ratio=Total DebtTotal Equity×100\text{Debt-to-Equity Ratio} = \frac{\text{Total Debt}}{\text{Total Equity}} \times 100
2. Debt Ratio – Compares total debt to total assets: Debt Ratio=Total DebtTotal Assets×100\text{Debt Ratio} = \frac{\text{Total Debt}}{\text{Total Assets}} \times 100
3. Equity Ratio – Measures the proportion of assets financed by shareholders: Equity Ratio=Total EquityTotal Assets×100\text{Equity Ratio} = \frac{\text{Total Equity}}{\text{Total Assets}} \times 100

How to Interpret Gearing Ratios

• High Gearing (>50%) – The company is heavily reliant on debt, which increases financial risk but may also indicate aggressive expansion.
• Moderate Gearing (25%-50%) – A balanced capital structure with manageable debt levels.
• Low Gearing (<25%) – The company relies more on equity financing, reducing financial risk but potentially limiting growth opportunities.

Advantages and Disadvantages of Gearing

Advantages:

• Leverage for Growth – Companies can use debt to expand operations and increase returns.
• Tax Benefits – Interest payments on debt are tax-deductible, reducing taxable income.
• Higher Earnings Potential – If investments generate higher returns than debt costs, gearing can enhance profitability.

Disadvantages:

• Financial Risk – High debt levels increase the risk of default during economic downturns.
• Interest Costs – Higher debt leads to increased interest payments, impacting profitability.
• Investor Perception – Excessive gearing may discourage investors due to financial instability.

How to Reduce a High Gearing Ratio

• Increase Equity Capital – Issue new shares to raise funds and reduce reliance on debt.
• Improve Profitability – Higher earnings can help repay debt and lower financial leverage.
• Refinance Debt – Negotiating lower interest rates or extending repayment terms can ease financial pressure.
• Reduce Costs – Cutting unnecessary expenses improves cash flow and debt management.

FAQs

What is a gearing ratio in finance?

The gearing ratio measures a company’s financial leverage by comparing its debt to equity or total assets.

Why is the gearing ratio important?

It helps investors and analysts assess a company’s financial health and risk exposure.

What is a good gearing ratio?

A moderate gearing ratio (25%-50%) is generally considered healthy, balancing risk and growth potential.

How do you calculate the gearing ratio?

It is calculated using different formulas, such as the debt-to-equity ratio or debt ratio.

What does a high gearing ratio indicate?

A high gearing ratio suggests high financial risk due to significant reliance on borrowed funds.

Can a low gearing ratio be bad?

Yes, a very low gearing ratio may indicate underutilisation of financial leverage, potentially limiting growth.

How can a company lower its gearing ratio?

By increasing equity capital, reducing debt, improving profitability, or refinancing existing loans.

What is the difference between gearing and leverage?

Both measure financial risk, but gearing focuses on debt relative to equity, while leverage refers to the overall use of borrowed funds.

How does gearing affect shareholders?

High gearing increases financial risk but can boost returns; low gearing reduces risk but may limit expansion.

Is gearing ratio relevant to all industries?

Yes, but capital-intensive industries (e.g., manufacturing, real estate) typically have higher gearing than service-based industries.