Key takeaways
– Gearing ratios measure financial leverage: how much of a company’s operations are funded with debt versus shareholders’ equity.
– Common gearing ratios: debt-to-equity, debt ratio, equity ratio, and times‑interest‑earned (interest coverage).
– Interpret gearing by comparing to industry peers, company history, and the firm’s cash‑flow stability; a higher gearing ratio implies greater financial risk but not necessarily poor performance.
– Use gearing ratios together (coverage + leverage + trend analysis) and account for accounting differences and off‑balance‑sheet items.
Source: Investopedia — “Gearing Ratio” (Xiaojie Liu) — https://www.investopedia.com/terms/g/gearingratio.asp
1. What are gearing ratios?
Gearing ratios are financial ratios that compare owners’ equity (shareholders’ funds) to borrowed funds (debt). They quantify financial leverage — the extent to which a company relies on creditors rather than owners to finance assets and operations. Higher gearing means more debt relative to equity and usually higher financial risk (more fixed obligations to service).
2. Key gearing ratio formulas and what they show
– Debt-to-Equity Ratio = Total Debt / Total Equity
– Shows how much debt a company uses for each dollar of equity.
– Debt Ratio = Total Debt / Total Assets
– Shows the percentage of assets financed with debt.
– Equity Ratio = Equity / Assets
– Complement to the debt ratio: percentage of assets financed with owners’ funds.
– Times Interest Earned (TIE) or Interest Coverage = EBIT / Interest Expense
– Measures ability to meet interest payments from operating earnings.
Notes on inputs:
– “Total Debt” typically = short‑term borrowings + long‑term debt (some analyses add current maturities of long‑term debt). Definitions can vary by user and covenant.
– “EBIT” = earnings before interest and taxes. Some lenders use EBITDA (adds back depreciation & amortization) for coverage measures.
3. Interpreting gearing ratios
– Higher gearing (higher debt-to-equity or debt ratio) → greater leverage and vulnerability to downturns (because debt servicing is fixed).
– Lower gearing → more equity cushion, less default risk.
– Industry and business model matter: capital‑intensive industries (utilities, telecoms) commonly operate with higher gearing because assets are stable and long‑lived; fast‑growth or cyclical firms usually target lower gearing.
– Compare to:
– Industry peers,
– Company historical trend,
– Lender covenants and rating agency thresholds.
– Combine leverage ratios with coverage ratios (TIE) and cash‑flow metrics to get a fuller picture.
4. Times Interest Earned (interest coverage) — deeper look
– Formula: TIE = EBIT / Interest Expense.
– Interpretation:
– TIE > 1: EBIT covers interest; >3 is typically comfortable for many lenders.
– TIE cost of debt.
Step 5 — Stress test:
– Model lower sales or margins and recalculate TIE and leverage under adverse scenarios.
– Check liquidity (current ratio, free cash flow) and upcoming debt maturities.
Step 6 — Take action / set policy:
– For management: set target leverage ranges, limit dividend/buyback policies that worsen covenant compliance, or deleverage via asset sales or equity raises when appropriate.
– For lenders: set covenants (e.g., TIE ≥ 3.0, Debt-to-EBITDA ≤ X) and require reporting frequency.
– For investors: incorporate gearing into valuation risk premium and consider bond vs. equity exposure.
8. Industry and contextual considerations
– Regulated utilities and monopolistic firms often sustain higher gearing because cash flows are stable and predictable.
– Capital‑intensive industries (airlines, utilities) routinely have higher debt ratios.
– High gearing is not automatically bad — if earnings are stable and interest costs are low relative to returns, leverage can amplify shareholder returns. But leverage magnifies losses in downturns.
9. Limitations and cautions
– Accounting differences: definitions of debt/equity and treatment of leases vary (e.g., IFRS 16 affects lease liabilities).
– Off‑balance‑sheet obligations (operating leases pre‑IFRS 16, guarantees, pension deficits) can understate true leverage.
– One ratio in isolation is insufficient; combine leverage, coverage, liquidity, profitability, and cash‑flow analysis.
– Short‑term coverage and upcoming maturities matter more than a static ratio snapshot.
10. The bottom line
Gearing ratios are essential tools to evaluate how a firm finances its assets — by debt or equity — and how comfortably it can service its obligations. Use multiple gearing measures (leverage + coverage), benchmark to industry peers and history, stress test for adverse scenarios, and account for accounting nuances and off‑balance‑sheet commitments. A high gearing ratio flags higher financial risk but must be interpreted in context (industry norms, cash‑flow stability, cost of debt and strategic positioning).
Further reading and source
– Investopedia, “Gearing Ratio” — Xiaojie Liu: https://www.investopedia.com/terms/g/gearingratio.asp
If you’d like, I can:
– Calculate gearing ratios for a specific company if you provide its balance sheet and income statement figures, or
– Prepare a one‑page checklist and covenant template tailored to your industry.