What Is Gearing Ratio?
Gearing ratios are a type of metric used by investors to analyse a company’s financial leverage. In other words, gearing ratios demonstrate the degree to which a company’s operations are funded by debt and, consequently, can help paint a picture of the financial health and stability of a business.
In this article, we will explore the concept of gearing ratio in detail, highlighting the most common gearing ratios, how they are calculated and providing examples of analysing gearing ratios in different industries.
Table of Contents
What Is Gearing Ratio?
Gearing ratios are a group of financial metrics which assess the financial leverage of a company. They are used to measure the amount of debt a company uses to fund its operations in comparison to either its assets or equity.
Gearing ratios are useful for different groups of people looking at different things. From an investing perspective, a gearing ratio can help investors understand the financial state of a company, to what extent its operations are financed by debt and its consequential exposure to risk.
There are several different gearing ratios which measure slightly different things. In the following section, we will look at some of the most commonly used gearing ratios and how to calculate them.
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Formula for Calculating Gearing Ratio
As mentioned previously, there is no single gearing ratio. Rather, gearing ratios are a group of financial metrics which each show something slightly different. In the following sections, we have highlighted three of the most common ones: Debt-to-Equity Ratio, Debt Ratio and Equity Ratio.
Debt-to-Equity Ratio
| Debt to Equity Ratio = Total Debt / Total Shareholder Equity |
The debt-to-equity ratio examines to what degree a company is financing its operations with debt versus equity capital (capital that is not tied to debt).
It is calculated by dividing a company’s total debt by shareholder equity. In order to find this information, you will need to consult the company’s balance sheet, which can be found in its most recent earnings report.
If it doesn’t appear on the balance sheet, shareholder equity can also be calculated by subtracting a company’s total liabilities from its total assets. It essentially demonstrates how much cash would be left over if a company were to sell all its assets and pay off all its liabilities.
In terms of total debt, this generally encompasses both short-term and long-term borrowings and capital leases – all of which are listed under liabilities on a company’s balance sheet. However, you will find that different people include different items when calculating total debt.
Equity Ratio
| Equity Ratio = Total Shareholder Equity / Total Assets |
The equity ratio is calculated by dividing a company’s total shareholder equity by its total assets.
The equity ratio, or shareholder equity ratio, looks at things from the perspective of shareholders’ equity. It essentially indicates what proportion of a company’s assets have been financed by shareholder equity, with an equity ratio of 1 implying that a company’s asset requirements have been funded solely by equity capital.
Debt Ratio
| Debt Ratio = Total Debt / Total Assets |
Unlike the equity ratio, the debt ratio examines things from a debt perspective. It is calculated by dividing a company’s total debt by its total assets.
The debt ratio demonstrates what proportion of a company’s asset requirements has been funded by debt. A debt ratio greater than 1 implies that a company has more debt than assets.
Interpretation of Gearing Ratio
Generally speaking, given the inherent risk accompanied by high levels of debt, investors tend to look more favourably upon companies with lower gearing ratios. A lower degree of leverage suggests a lower probability of bankruptcy, easier access to capital in the future and less sensitivity to increased interest rates.
But what constitutes a low or a high gearing ratio?
As is the case with many financial ratios, looking at gearing ratios in isolation does not provide investors with an awful lot of information. Whilst, on its own, it can give an idea as to the financial structure of a company, a gearing ratio is far more informative when compared with other companies which operate in the same industry.
In this way, investors can identify if a company has either a high, low or normal gearing ratio in comparison with the industry average.
The Importance of Gearing Ratios
Gearing ratios are important metrics for investors, as they can indicate how leveraged a company is and its consequential exposure to financial risk. Besides being used to analyse a prospective investment, gearing ratios can be useful for different purposes for different entities.
Lenders will consider gearing ratios when deciding whether, and under what terms, to extend credit to a company. The consequential loan agreement may also contain stipulations as to acceptable gearing ratios for the company during the term of the loan.
Companies themselves will also monitor their own gearing ratios to help manage their debt levels and predict future cash flow.
Examples of Gearing Ratios in Different Industries
As previously mentioned, there is not really a specific cut-off point for what is considered high or low when it comes to gearing ratios. Rather, companies should be compared with peers to establish whether or not their gearing ratio is high, low or average for their industry.
For example, companies which operate in capital intensive industries - such as utilities – require substantial investment in developing, maintaining and upgrading infrastructure. Consequently, these types of industries tend to have a higher degree of leverage than companies which don’t require such high levels of capital expenditure.
Furthermore, different industries may be able to handle increased levels of debt with varying abilities. Companies which operate in non-cyclical industries – again, such as utilities - tend to generate reliable income as there is constant demand for their goods and services. This means they are better positioned to service higher levels of debt than companies which produce goods and services for which demand constantly fluctuates.
Therefore, you might expect companies in non-cyclical industries to operate with higher leverage than those in cyclical industries.
As is often the case, all of this is probably best understood by looking at some real-life examples.
Gearing Ratios in UK Utilities
We have mentioned utility companies a few times already, so let’s look at this industry again for our first example.
There are five utility companies in the FTSE 100, all of which are highlighted in the table below together with their total debt, debt-to-equity ratio, debt ratio and equity ratio according to their most recent results. We have also included each company’s market capitalisation at the time of writing.
Source: Centrica, SSE, National Grid, Severn Trent and United Utilities – Annual and Interim Reports.
From the above table, we can see that, by every metric, United Utilities is the most highly leveraged company of the four, with Severn Trent not far behind.
On the other hand, Centrica has by far the lowest debt-to-equity and debt ratios. Nevertheless, SSE’s equity ratio is the highest of the four, implying that the proportion of its assets funded by shareholder equity is the highest.
If looking at things strictly from a debt perspective, an investor might conclude that Centrica represents the lowest risk investment. However, remember that investors should never make decisions based on only one set of metrics.
Whilst Centrica is the least leveraged company, and also has the strongest balance sheet of the five, this information isn’t enough to make an investment decision. Gearing ratios tell us nothing about how the company is actually performing.
Something which demonstrates the importance of not focusing too much on one piece of data is the total debt column. National Grid’s total debt dwarfs the other four but, as well as being a considerably larger company than the others, its gearing ratios are around or better than the average. The nominal value of a company’s debt doesn’t necessarily tell us the whole story about how leveraged that company is.
It’s also worth noting that National Grid operates a monopoly on electricity transmission in England and Wales. Companies which operate under monopolistic conditions can afford to operate with higher levels of debt as they don't need to worry about competition and, consequently, are at lower risk of default.
Gearing Ratios in UK Technology Stocks
Technology is an asset-light industry, meaning that investors can expect to find lower gearing ratios amongst tech stocks than in capital intensive industries such as utilities.
There are a number of technology companies in the FTSE 250 stock index, in the table below, we examine the largest five, looking at the same information as we did for utility companies in the previous section. As before, total debt and gearing ratios have been calculated using the most recent results.
Source: Softcat, Computacenter, Bytes Technology Group, MONY Group, Baltic Classifieds Annual and Interim Reports.
The difference in terms of how leveraged these companies are compared with the utilities examples we saw is stark. The highest debt-to-equity and debt ratios of the technology companies above are lower than the lowest of the utilities.
Again, this not only highlights the importance of comparing a company’s gearing ratios with its competitors, but also how much these ratios can differ between industries.
Conclusion
Gearing ratios can be an important type of metric for investors to look at when considering investing in a company. A high gearing ratio can cause alarm bells for investors, as it could indicate a company is operating in an unsustainable manner. Remember that to see the full picture, gearing ratios should be compared with the industry average.
It is also important to remember not to fixate on any one type of metric when analysing a company. Gearing ratios are no doubt important and can highlight potential risks of investing in a specific company, but they should be looked at in conjunction with other indicators.
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