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Gearing ratios form a broad category of financial ratios, of which the debt-to-equity ratio is the predominant example. Accountants, economists, investors, lenders, and company executives use gearing ratios to measure the relationship between owners’ equity and debt.
Gearing ratios are one way to differentiate financially healthy companies from troubled ones. All companies balance the advantages of leveraging their assets with the disadvantages of borrowing risks.
Key Takeaways
- Gearing ratios constitute a broad category of financial ratios.
- The debt-to-equity ratio is a gearing ratio.
- Accountants, economists, investors, and other financial professionals use gearing ratios to measure the relationship between owners’ equity and debt.
Gearing vs. Leverage
“Gearing” refers to the use of debt. Gearing is a leverage analysis of the owner’s equity, often expressed as a ratio in financial analysis. Gearing ratios focus on leverage more than other ratios used in accounting or investment analysis. The underlying principle assumes that some leverage is good, but too much places an organization at risk.
At a fundamental level, gearing can be differentiated from leverage. Leverage refers to the amount of debt incurred to invest and obtain a higher return, while gearing compares debt with total equity—or an expression of the percentage of company funding through borrowing. This difference is found when comparing the debt ratio and the debt-to-equity ratio.
Gearing and leverage are used interchangeably. European entities tend to use the term “gearing” while Americans refer to it as “leverage.”
What Is the Debt-to-Equity Ratio?
The debt-to-equity ratio compares total liabilities to shareholders’ equity. It is one of the most widely and consistently used leverage/gearing ratios, expressing how much suppliers, lenders, and other creditors have committed to the company versus what the shareholders have committed.
Different variations of the debt-to-equity ratio exist, and unofficial standards are used among separate industries. For example, banks often have preset restrictions on the maximum debt-to-equity ratio of borrowers for different types of businesses defined in debt covenants.
A D/E ratio below 1 may be considered relatively safe, whereas values of 2 or higher might be considered risky. For example, A ratio of 1.5 indicates a company has $1.50 of debt for every $1 of equity.
What Gearing Ratios Mean for Investors
Gearing or leverage ratios help investors understand a company’s economic health and if an investment is worthwhile or not. A company with a high gearing ratio generally has a riskier financing structure than a company with a lower gearing ratio. However, regulated entities typically have higher gearing ratios because they can operate with more debt.
Companies in monopolistic situations may operate with higher gearing ratios because their strategic marketing position puts them at a lower risk of default. Industries that use expensive fixed assets typically have higher gearing ratios because these fixed assets are often financed with debt.
Is a High Debt-to-Equity Ratio a Bad Indicator?
Debt-to-equity, like all gearing ratios, reflects a business’ capital structure. A higher ratio is not always a poor indicator, because debt can be a cheaper source of financing and comes with increased tax advantages.
What Affects a Company’s Gearing Ratios?
The size and history of specific companies must be considered when analyzing gearing ratios. Large, well-established companies can push their liabilities to a higher percentage of their balance sheets without raising serious concerns. Companies that do not have long track records of success are much more sensitive to high debt burdens.
What Are Types of Gearing Ratios?
Besides the Debt-to-Equity ratio, other gearing ratios include the times interest earned ratio and the shareholder-equity ratio. The TIE ratio shows how well a company can pay the interest on its debts. The shareholder-equity ratio shows how much of a company’s assets are funded by issuing stock rather than borrowing money.
The Bottom Line
Debt is inherently risky so investors favor businesses with lower gearing ratios. Gearing ratios include the debt-to-equity ratio. For investors, lower ratios commonly means companies can support their debt and have a decreased probability of bankruptcy in the event of an economic downturn.
