What Is a Good Ratio, and How to Calculate It
:max_bytes(150000):strip_icc()/business_building_153697270-5bfc2b9846e0fb0083c07d69.jpg "What Is a Good Ratio, and How to Calculate It")
A gearing ratio measures a company’s overall debt against its value. To stock analysts, investors, and lenders, the gearing ratio is an indicator of the company’s financial fitness. A company may be carrying too much debt or too little debt. The amount of debt that is perceived as healthy varies by industry.
Generally, a company that has a larger portion of debt in comparison to its shareholder equity has a high gearing ratio. A company that has a small proportion of debt versus equity has a low gearing ratio.
Key Takeaways
- There are several types of net gearing ratios but all compare company equity (or capital) to company debt.
- Net gearing is the most common type of gearing ratio and is calculated by dividing the company’s total debt by its total shareholders’ equity.
- The optimal gearing ratio depends on the industry.
Gearing Ratios: An Overview
The gearing ratio tells you how much of a company’s operations is funded by equity and how much is funded by debt.
Lenders use gearing ratios when they’re considering making loans. Corporate managers use them to make decisions about their use of cash and leverage. Here’s how these ratios are interpreted:
- High Gearing Ratio: The company has a larger proportion of debt versus equity
- Low Gearing Ratio: The company has a small proportion of debt versus equity
There are several variations of the gearing ratio. They include the equity ratio, debt-to-capital ratio, debt service ratio, and net gearing ratio. Each is calculated using a different formula.
High net gearing ratios can be a red flag. But they are more acceptable in certain industries. Businesses that need to invest heavily in property or manufacturing equipment often have relatively high debt.
The Most Common: Net Gearing Ratio
The net gearing ratio measures the level of a company’s overall debt compared to its value. It is the most commonly used gearing ratio in the financial markets. Most investors know it as the company’s debt-to-equity (D/E) ratio.
The D/E ratio measures how much a company is funded by debt versus how much is financed by equity. It compares a company’s total debt obligations to its shareholder equity.
The debt portion in the net gearing ratio may include the following:
- Short-term debt
- Long-term debt
- Accrued debt
- Accounts payable (AP)
- Financing agreements
- Leases
It’s important to compare the net gearing ratios of competing companies—that is, companies that operate within the same industry. Every industry has its own capital needs and relies on different growth rates.
How to Calculate the Net Gearing Ratio
The net gearing ratio (as a debt-to-equity ratio) is calculated by:
Net Gearing Ratio=Shareholders’ EquityLTD+STD+Bank Overdraftswhere:LTD=Long-Term DebtSTD=Short-Term Debt
Net gearing can also be calculated by dividing the total debt by the total shareholders’ equity. The ratio, expressed as a percentage, reflects the amount of existing equity that would be required to pay off all outstanding debts.
Capital gearing is a British term that refers to the amount of debt a company has relative to its equity. In the U.S., capital gearing is known as financial leverage and is synonymous with the net gearing ratio.
Good and Bad Gearing Ratios
An optimal gearing ratio is primarily determined by the individual company relative to other companies within the same industry. There are, however, a few basic rules for good and bad gearing ratios:
- Higher Than 50%: A gearing ratio in this range indicates the company is highly leveraged. The company would be seen as being at greater financial risk because it is more susceptible to default and bankruptcy during times of lower profits or higher interest rates.
- Between 25% and 50%: A gearing ratio within this range is typically considered optimal or normal for well-established companies.
- Lower Than 25%: Gearing ratios that fall under this value are typically considered low-risk by both investors and lenders.
| Gearing Ratio Guidelines | |
|---|---|
| 50% or more | High debt, high risk |
| 25% to 50% | Optimal or normal |
| 25% or Less | Low debt, low risk |
Gearing Ratios and Risk
The gearing ratio is an indicator of the financial risk associated with a company. If a company has too much debt, it has the potential to fall into financial distress. Remember: A high gearing ratio shows a high proportion of debt to equity, while a low gearing ratio shows the opposite.
Capital that is borrowed is riskier than capital from the company’s owners since creditors have to be paid back even if the business doesn’t generate income. A company with too much debt might be at risk of default or bankruptcy, especially if the loans have variable interest rates.
On the plus side, debt helps a company expand its operations, add new products and services, and ultimately boost profits. A company that never borrows might be missing out on opportunities, especially when loan interest rates are low.
Capital-intensive companies and those with a lot of fixed assets, like industrials, are likely to have more debt versus companies with fewer fixed assets. For example, utility companies typically have high gearing ratios. This is acceptable because these companies operate as regulated monopolies in their markets, which makes their debt less risky than companies in competitive markets.
Why Are Gearing Ratios Important?
Gearing ratios indicate the degree to which a company’s operations are funded by its debt versus its equity. High ratios relative to their competitors can be a red flag while low ratios generally indicate that a company is low-risk.
What Does the Net Gearing Ratio Tell You?
The net gearing ratio is the most common gearing ratio used by analysts, lenders, and investors. Also called the debt-to-equity ratio, it measures how much of the company’s operations are funded by debt compared to its equity.
Is It Better to Have a High Gearing Ratio?
A high gearing ratio can be a blessing or a curse—depending on the company and industry. Having a high gearing ratio means that a company is using more debt to fund its operations, which may increase the financial risk. But, high ratios work well for certain companies, especially if they are in capital-intensive industries. It shows they are investing in growth.
The Bottom Line
A safe gearing ratio can vary by company and is largely determined by how a company’s debt is managed and how well the company is performing. The gearing ratio must be viewed alongside other major numbers such as earnings growth, market share, and cash flow.
It’s also worth considering that well-established companies could pay off their debt by issuing equity if needed. In other words, having debt on the balance sheet might be a strategic business decision since it might mean less equity financing. Fewer shares outstanding can mean a higher stock price.
link
:max_bytes(150000):strip_icc()/FinancialAnalysis-edit-5b5ae0fdcc92481e8d69fe30c92629f8.jpg "Definition, Importance, Types, and Examples")
:max_bytes(150000):strip_icc()/PEG-Ratio_Final_4191448-6df4ad0f7a2842bb86915ba99293a23e.jpg "Using the Price-to-Earnings (P/E) Ratio and PEG Ratio to Assess a Stock")
:max_bytes(150000):strip_icc()/GettyImages-1173599543-fcb23edb4e3b47b0b815c7390e4f677d.jpg "Google’s 5 Key Financial Ratios (GOOG)")
