Gearing Ratios

Why should I care about gearing ratios?

For markets: High gearing ratios indicate that companies are highly-leveraged, making them riskier prospects to shareholders during economic downturns. Low gearing ratios, meanwhile, suggest companies are more equity-financed, which may provide greater stability and flexibility during periods of financial stress.

The bigger picture: The aggregate gearing ratio of companies within a country or region can help indicate its overall financial health and stability. Economies where companies operate with high levels of debt might be more susceptible to economic shocks, affecting everything from stock market performance to job security across sectors.

Common gearing ratios

• Net gearing ratio: This ratio shows a company’s net debt as a percentage of its total capital. It helps investors understand the extent to which a company is financed through debt compared to equity.
• Debt to equity ratio: This measures a company's financial leverage by comparing its total liabilities to shareholders' equity. It's used to evaluate the balance between the funds provided by creditors and the funds provided by shareholders.
• Times interest earned (TIE): Also known as the “interest coverage ratio”, it measures a company's ability to meet its interest repayment obligations based on its current earnings (assuming both stay stable). It is calculated by dividing a company’s annual earnings before interest and taxes (EBIT) by its annual interest expenses.
• Equity ratio: This ratio compares shareholders' equity to total assets to indicate how much of a company is financed by owners' investments. This ratio provides insight into the financial stability of the company.
• Debt ratio: This ratio compares a company's total debt to its total assets, showing how much of the company's assets are financed through debt. It's a measure of financial leverage and risk.

Why are gearing ratios important?

• Utility for internal and external parties: Gearing ratios are crucial for companies to manage their debt levels strategically and for investors assessing a company's financial health and stability.
• Resilience in an economic downturn: These ratios help gauge a company's ability to withstand economic downturns. A lower gearing ratio suggests a company has more equity relative to debt, providing a cushion against financial stress.
• Cash flow analysis: Gearing ratios are instrumental in analyzing a company's cash flow capabilities, especially their ability to service debt, which is crucial to a firm continuing its operations.
• Assessing credit worthiness: Financial institutions as well as bond investors often rely on these ratios when deciding whether to extend credit or invest in a company’s bonds. High gearing ratios may indicate higher risk, potentially affecting loan terms or even the decision to lend. And for bond investors, it’ll impact the price they’re willing to pay for company bonds. What’s more, credit rating agencies will look at these ratios too and use it to inform their company ratings, which in turn will influence investors’ views.

How to interpret gearing ratios

A high gearing ratio typically indicates a high degree of financial leverage and suggests a riskier financial structure – but doesn’t necessarily mean a company is in poor financial health. Healthy companies with high gearing ratios – that rely heavily on debt to finance their operations – might see higher financial risk as justified if they’re operating in industries that require significant capital investment but that have steady and predictable cash flows.

High leverage: A high gearing ratio means a company uses more debt in its capital structure. While this could mean greater risk, especially in economic downturns, it does not automatically imply poor financial health. Companies with stable cash flows should be able to manage higher debt levels effectively.

Risk assessment: Generally, a higher gearing ratio is seen as riskier than a lower one because it means more debt relative to equity. This can affect a company's ability to secure new loans on favorable terms.

Industry specifics: Industries such as utilities, telecommunications, and transportation often operate with higher gearing ratios due to the intensive capital expenditures required for infrastructure and equipment. These sectors tend to have stable, often government-regulated, long-term revenues that can support higher levels of debt.

Formulas and how to calculate gearing ratios

What is a good or bad gearing ratio?

Determining what constitutes a good or bad gearing ratio largely depends on the industry context and specific financial strategies of a business. What might be considered high risk in one industry could be standard in another. So, always consider the broader economic context and specific industry standards when evaluating the implications of a gearing ratio. That said, these benchmarks can provide a guide:

• Higher than 50%: This is typically considered highly leveraged or geared. Companies with gearing ratios above 50% are seen as having high financial risk: they may be more vulnerable to loan defaults and bankruptcy, particularly if faced with sudden economic downturns.
• Between 25% and 50%: Ratios within this range are typically optimal for established businesses. It suggests a balanced approach to financing with a healthy mix of debt and equity, and is often suitable for companies that want to use debt to fuel growth while maintaining a manageable risk level.
• Lower than 25%: Gearing ratios below 25% are generally considered low-risk by investors and lenders. Such companies are less reliant on borrowed funds, which may appeal to conservative investors or those looking for stability in turbulent markets.

Gearing ratios and risk

Gearing ratios serve as a vital tool for assessing financial risk, providing insights into the level of debt a company carries relative to its equity. High gearing ratios suggest a company is heavily reliant on debt financing, which, while potentially amplifying profits, increases the financial risk, particularly if the company faces cash flow issues. This situation can lead to financial distress if the company struggles to meet its obligations due to high interest and debt repayment costs.

Capital borrowed from creditors (i.e. debt) is generally considered riskier than capital borrowed from shareholders (i.e. equity) because creditors must be repaid regardless of the company's financial performance, whereas shareholders are usually only repaid (via dividends, for instance) once a company’s profitable. The need to repay creditors can impose a significant financial burden on companies, particularly during economic downturns, and potentially lead to default or even bankruptcy. That’s all the more true for debt that is subject to variable interest rates that may increase unexpectedly.

However, taking on debt isn't always negative: it’s also be a strategic tool for growth. After all, companies use borrowed capital to expand their operations, launch new products, or enter new markets – all of which can lead to increased profits. Companies that avoid debt altogether may miss out on these growth opportunities, especially when borrowing costs are low, thereby limiting their potential for expansion and profitability.

Different industries have varying norms as far as gearing ratios go. Capital-intensive industries, like utilities or telecoms, often have higher gearing ratios than other sectors due to their need for significant upfront investment in fixed assets. The stable cash flows and regulated nature of these industries can support higher levels of debt more comfortably than more cyclical sectors.

How can companies reduce their gearing?

• Selling shares: Issuing more equity can raise capital to pay down debt.
• Converting loans: Switching short-term debt to longer maturities or converting debt into equity can improve liquidity and reduce pressure.
• Reducing operating costs: Cutting expenses boosts net income and free cash flow, allowing more funds to be allocated to debt reduction.
• Increasing profits: Boosting revenue and enhancing operational efficiency can provide more cash with which to address debt obligations.