What is a gearing ratio?
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Financial gearing ratios are often used to measure a company’s liquidity and exposure to risk. Gearing ratios are a set of measures that assess the proportion of a company’s finance that is provided by long-term debt. They are often used to measure a company’s liquidity and exposure to risk, since high borrowing can be risky for businesses, as repayments and interest might not be affordable in the future.
But although gearing can be related to risk, it’s important to note that debt isn’t always a negative for growing businesses. If your company has strong, predictable revenues, then debt can be a useful source of funding for development and expansion.
Types of gearing ratios
A company's liquidity and exposure to risk can be calculated using several different gearing ratios. The three most common types are:
- Debt-to-equity ratio: Measures the financial leverage of a business by comparing total liabilities to shareholder equity.
- Equity ratio: Measures the proportion of business assets that are financed by shareholder equity.
- Debt ratio: Measures the proportion of business assets that are financed by debt.
It's also important to understand the difference between a current ratio and a gearing ratio. A current ratio focuses on short-term liquidity by comparing current assets and current liabilities. Gearing ratios, on the other hand, provide a longer-term picture as they assess risk by comparing debt-to-equity.
Gearing ratio formula
A gearing ratio formula measures a firm’s total debt and then compares it to a form of assets, such as capital or equity.
Debt-to-equity ratio formula
The debt-to-equity ratio can be calculated by subtracting shareholder equity from total liabilities, as follows:
Debt-to-Equity Ratio = Total Liabilities - Shareholder Equity
A healthy debt-to-equity ratio is generally around 1:1.5, meaning for every £1 a company takes on in debt, there should be £1.50 in equity.
Hip Pop makes gut-friendly drinks that are an alternative to mainstream soft drinks. The company has seen its revenue double each year for the last three years and has enjoyed rapid global expansion.
Funding this growth meant balancing debt and equity financing, says co-founder Emma Thackray. “Debt financing isn’t always easy to access as an SME because you don’t have the trading history," she says. "But where we use it, we are always conscious of balancing it with the available equity.
“Our early funding came from angel investors, but debt financing allows us to fund business operations without giving away more equity through equity finance, and thus retain a healthy debt-to-equity ratio.”
Debt ratio formula
To calculate the debt ratio, simply subtract total assets from total liabilities, as follows:
Debt Ratio = Total Liabilities - Total Assets
The debt ratio is important because it helps a business evaluate risk. For example, a higher debt ratio might be more indicative of debt resilience, which may be risky if a company faces financial hardship or difficulty. The debt ratio also helps a business understand whether it can meet its long-term financial obligation, giving a picture of solvency.
Equity ratio
To calculate the equity ratio, simply subtract total assets from shareholder equity, as follows:
Equity Ratio = Shareholder Equity - Total Assets
The equity ratio is important because it can give a picture of financial stability. Higher equity ratios generally point to a stronger base of equity, meaning a company is less reliant on borrowing. Moreover, it helps assess financial risk.
What does gearing mean for businesses?
Financial gearing refers to relative amounts of debt and equity that a company uses to support ongoing business operations².
“The financial gearing ratio measures how high debt is, in relation to equity, and a high ratio suggests a company relies on large amounts of debt to operate,” says Gary Hemming, an independent commercial finance advisor.
Understanding the financial gearing ratio of a business can provide useful insight, especially when comparing against other businesses in the same industry.
What is a good gearing ratio percentage?
A highly geared business is one with higher debt and higher gearing ratios. Typically, a gearing ratio of 50% or more is considered highly geared or 'highly leveraged'. However, in some industries such as telecoms, where businesses need to buy expensive machinery upfront, a highly geared business is perfectly normal.
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“There’s no one size fits all figure that makes a business highly geared, and no ‘correct’ debt to equity ratio,” says Hemming. Instead, it’s important to consider gearing for any business compared to the industry average. “By looking at a company’s peers, it’s easy to create simple benchmarking,” he says.
For example, industries like recruitment and haulage typically rely on invoice financing and might borrow up to 95% of outstanding invoices at any one time. “While this is normal for those industries, it would be seen as a red flag in other sectors,” Hemming adds.
How to manage a gearing ratio
To balance gearing ratios, a business should look to balance debt with equity². This can be achieved through more effective profit generation and controlled expense management.
Improved gearing ratios can also occur indirectly as the result of a company pursuing other business goals, such as:
- Maintaining financial stability by optimising profit and controlling debt
- Improving creditworthiness through lower gearing ratios
- Optimising capital structure by balancing profits and expenses
- Avoiding financial difficulty by controlling expenses and managing debt
Limitations of gearing ratios
The key limitation of gearing ratios is that they must be viewed in the context of a particular industry. “Companies could be facing enormous risk or no risk at all, while having the same gearing ratio,” says Hemming. For example, a business that has a monopoly in a certain sector has less risk than one with the same gearing ratio but many direct competitors.
In addition, some companies could be struggling for finance and facing substantial risk without having any debt at all – in which case a gearing ratio could be misleading.
How does a high gearing ratio impact lending?
If a company’s gearing ratio is low, compared to its competitors, then it’s likely to make it easier to secure additional investment, including additional debt financing. A company that appears to be over-leveraged is likely to find it harder, or more expensive, to secure this funding.
What does the gearing ratio say about risk?
A higher gearing ratio indicates higher risk because if interest rates increase, then profit margins can be squeezed very easily, says Hemming. “Equally, where revolving debt is used to support cash flow, should that debt become less available (either a lower amount or a delay in getting funds), there is often an immediate hole in cash flow.”
Long-term debt can provide a viable and affordable way to fund business operations. However, this should be managed with an awareness of the ongoing gearing ratios. Should a gearing ratio start to rise outside of industry norms, this is an indication that a business could be at risk from unexpected increases in costs, for example in its supply chain, or a drop in revenue.
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