What Does a Company’s Gearing Ratio Tell You About them?

What Does “Gearing Ratio” mean?

The managers of a company, or the potential lenders to a company, need a good way of assessing how firmly it is standing on its own two feet. For instance, if a company is largely running on borrowed capital, this could cause lenders’ ears to prick up. The reason is that, in the event interest rates were to be significantly raised, or the company’s revenue inflows would slow down, they may run into trouble in paying off their debt, which could eventually lead to their bankruptcy. Even though the company may be reporting robust earnings at the moment, a forward-looking lender may choose to pass them over in favour of a less leveraged competitor, whose financial roots are perceived as more firmly entrenched, and who thus looks more likely to weather an economic storm.

The tool they use to assess this matter is called a gearing formula, which gauges the company’s debt in relation to its shareholder equity. When you take company debt and divide it by the equity it has issued, you end up with the debt-to-equity (D/E) ratio, otherwise known as “net gearing”, which is the most popular gearing ratio employed by analysts. This is most likely the meaning of “gearing ratio” when you hear the term used in the financial news. Just by looking at the gearing ratio formula, you can get an idea of how the financial structure of the company is laid out and, therefore, of its vulnerability to rocky economic conditions.

Aside from the D/E ratio, the other gearing ratio formulae you are likely to encounter are the debt ratio, which we arrive at by dividing total debt by total assets; and the equity ratio, which divides equity by assets. Depending on your research needs, you may find either of these useful in assessing financial risk for your online trading deals.

If debt were equal to equity, you would come out with a net gearing ratio of 1. The more that debt outweighs equity, the higher the ratio would go: from 1.1 to 1.2, and even 4 or higher. Some people choose to express these ratios as percentages, so they would appear, respectively, as 100%, 110%, 120%, and 400%. Looking at the case of a company whose total debt amounted to $1 billion, but whose shareholder equity equaled $5 billion, their D/E ratio would be one divided by five: namely, 20%.

Gearing ratio formulas

Debt to equity ratio

Debt to equity ratio calculates the gearing ratio of a business by using the debt to equity measure. Simply put, it is the business’s debt divided by company equity.

Debt to equity ratio = total debt ÷ total equity

The debt to equity ratio can be converted into a percentage by multiplying the fraction by 100. This is an easier way to understand the gearing of a company and is the general common practice.

Debt to equity percentage = (total debt ÷ total equity) × 100

Debt ratio

Debt ratio is similar to the debt to equity ratio above, but it measures total debt against total assets and provides a measure to which degree a business’s assets are financed by debt.

Debt ratio = total debts ÷ total assets

Equity ratio

Equity ratio gives a measure of how financed a firm’s assets are by shareholder’s investments. Unlike the other gearing ratios, a higher percentage is often better.

Equity ratio = total equity ÷ total assets

However, the gearing formula is not a stand-alone metric. In order to determine how much debt is acceptable for a company to take on, you’ll have to first consult the industry norm. Some firms typically operate on high levels of debt, without it being any kind of a problem. For instance, companies might feel confident working with elevated debt levels if they enjoy a monopoly over a particular sector, or if government regulation guarantees their market share.

An example would be a large American electric company, whose persistently high gearing ratio wouldn’t necessarily bother anyone. In such a case, it’s understood that the company operates with high-priced fixed assets that elevate debt levels, and that this need not imply they stand on a wobbly foundation. By contrast, if a company’s gearing ratio towers over other firms operating in the same industry, there is reason to believe their financial footing could, in fact, be relatively weak.

When Net Gearing is an Alarm Bell

There can’t be a universal standard for acceptable and unacceptable gearing ratios because each industry has a different degree of need for capital, and also anticipates growth at its own unique pace. However, it’s possible to give some general guidelines which can be useful in a large portion of cases. A gearing ratio below 25% is considered a sign that a company is looking financially sound, since it shows they operate on a relatively small amount of debt. If the ratio exceeds 25% but comes in less than 50%, this would usually be viewed as a sign of normal and healthy financial structuring. Finally, if you see a company’s gearing ratio stretching beyond the 50% mark, its high leverage levels start to make it look riskier.

Back in 2021, JP Morgan estimated that Evergrande, the heavily indebted Chinese property giant, was running a net gearing ratio of at least 177% in the first half of that year. This came in the face of the company’s officially reported ratio of only 100%, which Evergrande had arrived at by “[shifting] some its interest-bearing debt to off-balance sheet debt”, in JP Morgan’s words. The firm purportedly did this in order to give the impression they were obeying new laws that restricted company borrowing. These laws, which were suddenly slapped on Chinese property companies in 2020, immediately put the highly leveraged firm in a difficult position. Evergrande was finally ordered to liquidate in January of 2024 after the failure of their debt restructuring plan. Only six years before, they had been rated as the most valuable property company in the world.

In the case of Evergrande, we know their debt levels indeed turned out to be an insoluble problem, but it’s also true that their crisis was precipitated by an abrupt new policy on debt, to which it proved impossible for the company to adapt. Indeed, gearing ratios in the property industry can sometimes range as high as 800% due to their high upfront expenditures. Whether or not ratios this high can be acceptable depends on the kind of property they build, and also the nature of their financial structuring. The same would go for other firms that run on capital-intensive business models like gas refineries and telecommunications networks. These companies have to build enormous infrastructures before they can even begin delivering their goods or services, and this necessitates paying out big sums of money at the outset. This explains their typically high debt levels.

The Benefits of Debt

You might be inclined to negatively prejudge a company with a high net gearing, but there are other considerations to keep in mind. If a company never took on any debt, which could be done under quite favourable conditions when interest rates are low, it could miss out on the opportunity of evolving into a larger-scale business. Through taking out a loan, the firm would be able to, for instance, build a state-of-the-art production facility, which then could be used to churn out large quantities of high-demand products. As a result, their revenue might ultimately skyrocket, which could elevate the company to a much more dominant position in their market. In this way, a high debt level can signify, not so much a company’s financial vulnerability, as their ambitious plans for the future and their determination to avoid stagnating. 

In many situations, it is more cost-effective for a company to procure its financing through shouldering debt than through issuing equity. Companies may also like the fact that, in this way, they don’t have to give up control of any part of the business, which wouldn’t be the case with equity financing. On the other hand, companies know that, when they do choose to take on debt, they obligate themselves to pay it back on time, no matter how little cash is coming into their business in the meantime. A small or new business may find this prospect daunting. 

Some analysts have criticized video streaming company Netflix for the heavy reliance on debt financing that brought their D/E ratio up to 181% in the first quarter of 2019. However, others suggested that this need not imply there is any inherent problem in their business model, which requires high capital expenditures in order to produce compelling video content. When we look, for instance, at their return on capital for 2019, we see it outdid most of its competitors after showing steady improvement over the previous two years. This means their use of those borrowed funds appears to have been wisely managed. Besides, Netflix’s decision to operate on high debt levels was a calculated one. In the company’s own words, “Given low interest rates, the tax deductibility of debt and our low debt to enterprise value, financing growth through the debt market is currently more efficient than issuing equity”.  

Wrapping Things Up

We have learned that the gearing ratio formula is a quick, efficient means of estimating the extent to which a company’s operations run on debt financing, as opposed to equity financing. We have also learned that, in many cases, high debt levels can constitute an alarm bell in the minds of lenders, who view this as a sign of their vulnerability to economic conditions that may materialize in the future. At the same time, we can’t assess whether a high gearing ratio means a company’s financial structure is shaky without taking a close look at its industry competitors, who operate under similar conditions and with similar business models. Generally speaking, it is when a company’s D/E ratio dwarfs its peers’ that economists perceive a potential weakness in their financial structuring.

Knowing all this can be of assistance to you in your online trading. When you are researching a company’s fundamentals with the aim of opening a deal on their share prices, you may come across a quote of their gearing ratio. You now have a basis upon which to assess that figure, which you can build upon by finding out more about the company’s specific operations and its industry norms. It also helps to read what professional analysts say about the significance of a particular gearing ratio.