What Are Gearing Ratios?
Let me start by defining gearing ratios for you. These are financial ratios that compare some form of owner's equity or capital to the debt or borrowed funds of a company. Essentially, gearing measures the entity's financial leverage, showing how much of the firm's activities are funded by shareholders' funds versus creditors' funds.
You can think of the gearing ratio as a direct measure of financial leverage—it demonstrates the degree to which a firm's operations are funded by equity capital rather than debt financing.
Understanding Gearing Ratios
To understand gearing ratios, you need to know they form a group of financial metrics that compare shareholders' equity to company debt in different ways. Their main goal is to assess the company's level of leverage and overall financial stability.
Gearing specifically measures how much of a company's operations are funded using debt compared to the funding from shareholders as equity. These ratios gain more significance when you compare them against those of other companies in the same industry.
Here are the best-known examples of gearing ratios: the debt-to-equity ratio, which is total debt divided by total equity; the times interest earned, which is EBIT divided by total interest; the equity ratio, equity divided by assets; and the debt ratio, total debt divided by total assets.
If a company has a higher gearing ratio, it means it has a higher degree of financial leverage. This makes it more susceptible to economic downturns and business cycles because higher leverage means more debt relative to shareholders' equity. Companies with high gearing have more debt to service, while those with lower ratios rely more on equity for financing.
These ratios serve both internal and external purposes. Financial institutions use them to decide on issuing loans, and loan agreements might require companies to stay within certain gearing limits. Internally, management analyzes them for future cash flows and leverage planning.
Interpreting Gearing Ratios
When interpreting gearing ratios, a high ratio typically points to a high degree of leverage, but that doesn't always mean the company is in poor shape financially. Instead, it shows a riskier financing structure compared to a company with a lower ratio.
Regulated entities often have higher gearing ratios because they can handle more debt safely. Companies in monopolistic positions also tend to operate with higher ratios due to their strong market position reducing default risk. Industries with expensive fixed assets usually show higher gearing because those assets are often debt-financed.
Remember, you should always compare a firm's gearing ratio with those of other companies in the same industry for proper context.
Example of How to Use Gearing Ratios
Let me give you an example to illustrate this. Suppose a company has a debt ratio of 0.6. On its own, this tells you something about its financial structure, but it's far more useful when benchmarked against another company in the same industry.
If the company's debt ratio was 0.3 last year, the industry average is 0.8, and its main competitor has 0.9, then you can derive more insights. In this case, a 0.6 ratio means the company is performing relatively well compared to the industry average of 0.8 and the competitor's 0.9.
Frequently Asked Questions
You might wonder what the times interest earned ratio is—it's calculated by dividing earnings before interest and taxes (EBIT) by interest expenses, gauging the company's ability to pay its debts each period.
Shareholders' equity is the portion of a company's net assets belonging to its investors, appearing on the balance sheet and including par value of shares, additional capital, retained earnings, treasury stock, and accumulated comprehensive income.
Financial leverage is total assets divided by shareholders' equity, showing how much of the assets are funded by debt versus equity—a high ratio means significant debt funding.
The Bottom Line
In summary, gearing ratios compare a company’s equity to its debt, indicating financial leverage or how much operational debt is covered by shareholders’ equity and borrowed funds. This is a key measure of financial stability that you, as an investor, should monitor closely. A high gearing ratio can signal higher risk and potential red flags.
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