In this article we take a closer look at gearing ratios, including explaining what gearing is, what gearing ratios mean, and then how to calculate a gearing ratio. We also examine how companies use gearing and what the gearing ratio of a firm can tell us about the strength or weakness of that business.
What is a gearing ratio?
The term gearing ratio is used to describe how much debt a company has versus how much equity - in other words, how much of the business is funded by debt compared to being funded by equity, i.e shareholders.
Companies can raise money in two ways: they can sell shares or borrow. Many companies use both methods to finance their operations.
Companies listed on the stock exchange can stage initial or new share offerings, while private companies might sell equity in bespoke deals with third parties. This becomes equity funding.
In contrast, the process of borrowing to finance a company’s operations is known as ‘gearing’ or debt funding.
Borrowing money has the advantage of a company’s owners not having to give up all or part of their equity. The disadvantage is that borrowed money must be paid back with interest. Gearing ratios can help investors to gain a better understanding of the companies in which they invest, including their risk management.
How to calculate a gearing ratio
Several types of gearing ratios exist, but a commonly used gearing ratio formula is the debt-to-equity ratio.
For example, if a company has £1 million equity, or capital, value and total debts of £250,000, then its debt-to-equity ratio can be calculated by:
Debt-to-equity ratio = 250,000 / 1,000,000 = 0.25, or 25%
Debt can include long- and short-term debt as well as bank loans, leases, financing agreements, obligations to suppliers and other creditors, and overdrafts.
What can gearing ratios tell us?
When the proportion of its debt to equity is high, a company’s capital gearing is regarded as high, and vice versa.
A gearing ratio is a key indicator of a company’s level of indebtedness, which can highlight its financial strength, the level of risk it is running and commercial potential. If a gearing ratio is too high for a company given the market conditions in which it operates, then this could cause financial weakness and even bankruptcy. If it is too low, then it might be underinvesting and missing out on commercial opportunities.
The interpretation of the gearing ratio can depend on the type of company in question and the industry in which it operates. For example, companies working in industries requiring substantial outlays on capital equipment, such as energy, mining and telecommunications, will normally have high gearing ratios. However, companies in more cyclical industries, in which revenue can ebb and flow according to economic conditions, will prefer low gearing ratios as repayments on debt can deplete limited profitability in poor periods. This includes industries such as construction, leisure and luxury goods.
Generally, a gearing ratio above 50% is regarded as high, potentially putting a company at financial risk, especially in tougher economic conditions or high-interest rates. An optimal gearing ratio is typically regarded as being between 25% and 50% for established companies. A low-risk gearing ratio would typically be less than 25%.
How can companies reduce their gearing?
Given that the gearing ratio is based on two factors, a company can reduce its ratio by either increasing its equity/capital or reducing its debt.
The former can be achieved by issuing more shares or increasing the price of existing shares, by boosting profitability, for example. The proceeds from selling shares or greater profits can be used to pay off debt, further reducing the gearing ratio.
The other option is for companies to reduce their debts by settling more of it, perhaps by reducing their operational costs, or asking lenders to swap the debt for shares in the company.
Gearing ratio example
Gearing ratios are relevant for investors in investment trusts. As companies, investment trusts can borrow to invest more on behalf of their investors. If a trust’s managers are optimistic about the markets in which they invest, then gearing can enhance returns. If the returns achieved on the assets purchased with borrowed money exceed the interest paid to service the debt, then there is a positive net return for investors. The opposite can be true, too, of course.
If the shareholder capital of a trust is £10 million and the amount borrowed is £1 million, then the gearing ratio is 0.1, or 10%.
For example, analysis* by Trustnet, the fund data provider, found that the investment trust that increased its gearing the most in 2020 had raised it to 26% over that year from 16% at the end of 2019. The trust could take long and short positions, so was able to use the extra finance to trade more shares in a year that saw substantial market volatility.
Liontrust is manager of the Edinburgh Investment Trust, which invests predominantly in the UK stock market and has the option to gear investments. For more information, see: Edinburgh Investment Trust
*Source: Trustnet, 26 January 2021
