The gearing ratio measures the proportion of a company's borrowed funds to its equity. The ratio indicates the financial risk to which a business is subjected, since excessive debt can lead to financial difficulties. A high gearing ratio represents a high proportion of debt to equity, and a low gearing ratio represents a low proportion of debt to equity. This ratio is similar to the debt to equity ratio, except that there are a number of variations on the gearing ratio formula that can yield slightly different results.
A high gearing ratio is indicative of a great deal of leverage, where a company is using debt to pay for its continuing operations. In a business downturn, such companies may have trouble meeting their debt repayment schedules, and could risk bankruptcy. The situation is especially dangerous when a company has engaged in debt arrangements with variable interest rates, where a sudden increase in rates could cause serious interest payment problems.
A high gearing ratio is less of a concern in a regulated industry, such as a utility, where a business is in a monopoly situation and its regulators are likely to approve rate increases that will guarantee its continued survival.
Lenders are particularly concerned about the gearing ratio, since an excessively high gearing ratio will put their loans at risk of not being repaid. Possible requirements by lenders to counteract this problem are the use of restrictive covenants that prohibit the payment of dividends, force excess cash flow into debt repayment, restrictions on alternative uses of cash, and a requirement for investors to put more equity into the company. Creditors have a similar concern, but are usually unable to impose changes on the behavior of the company.
Those industries with large and ongoing fixed asset requirements typically have high gearing ratios.
A low gearing ratio may be indicative of conservative financial management, but may also mean that a company is located in a highly cyclical industry, and so cannot afford to become overextended in the face of an inevitable downturn in sales and profits.
How to Calculate the Gearing Ratio
The most comprehensive form of gearing ratio is one where all forms of debt - long term, short term, and even overdrafts - are divided by shareholders' equity. The calculation is:
(Long-term debt + Short-term debt + Bank overdrafts) ÷ Shareholders' equity
Another form of gearing ratio is the times interest earned ratio, which is calculated as shown below, and is intended to provide some indication of whether a company can generate enough profits to pay for its ongoing interest payments.
Earnings before interest and taxes ÷ Interest payable
Another variation on the gearing ratio is the long-term debt to equity ratio; it is not especially useful when a company has a large amount of short-term debt (which is especially common when no lenders are willing to commit to a long-term lending arrangement). However, it can be of use when the bulk of a company's debt is tied up in long-term bonds.
Gearing Ratio Example
In Year 1, ABC International has $5,000,000 of debt and $2,500,000 of shareholders' equity, which is a very high 200% gearing ratio. In Year 2, ABC sells more stock in a public offering, resulting in a much higher equity base of $10,000,000. The debt level remains the same in Year 2. This translates into a 50% gearing ratio in Year 2.
How to Reduce Gearing
There are a number of methods available for reducing a company's gearing ratio, including:
- Sell shares. The board of directors could authorize the sale of shares in the company, which could be used to pay down debt.
- Convert loans. Negotiate with lenders to swap existing debt for shares in the company.
- Reduce working capital. Increase the speed of accounts receivable collections, reduce inventory levels, and/or lengthen the days required to pay accounts payable, any of which produces cash that can be used to pay down debt.
- Increase profits. Use any methods available to increase profits, which should generate more cash with which to pay down debt.
Gearing is also known as leverage.