EN
The gearing ratio is an essential financial ratio that helps understand the extent to which a company relies on borrowed money for financing. It refers to the relationship between debt and equity. It is widely used by investors, lenders, and entrepreneurs to assess a company's risks.
This article explains the gearing ratio in detail, its benefits and limitations.
Key Takeaways
- The gearing ratio measures how much a company relies on borrowed money relative to shareholders' equity.
- Higher gearing ratios typically imply greater financial risks, whereas lower gearing ratios imply lower reliance on debt.
- The gearing ratio is helpful in fundamental analysis for comparing companies, analysing financial risks, and tracking changes in a company's capital structure.
- One should not rely solely on the gearing ratio; profitability, cash flows, interest cover, liquidity, and growth must also be considered.
- There is no ideal gearing ratio for every company, as the appropriate level depends on the industry, business model, and financial condition.
What is a Gearing Ratio?
The gearing ratio is a fundamental accounting metric that indicates the extent to which a company relies on borrowed money, such as long-term debt and bonds, compared to shareholders' equity.
Every company requires capital to operate and expand. These funds typically originate from two primary sources: internal equity (shareholder contributions and retained earnings) or external debt (bank loans and debentures). The gearing ratio establishes the precise proportion between these two buckets.
Core Formula
While minor variations exist across different brokerages and rating agencies, the most common formula is:
Gearing Ratio = Debt ÷ Equity × 100
If a company has ₹50 lakh of debt and ₹100 lakh of equity, the gearing ratio will be 50%. In other words, the company has ₹50 of debt for every ₹100 of equity.
| Financial Component | Amount (in Lakhs) | Ratio Breakdown |
| Total Debt | ₹50 lakh | Debt component used in numerator |
| Shareholders’ Equity | ₹100 lakh | Equity component used in denominator |
| Gearing Ratio | 50% | ₹50 of debt for every ₹100 of equity |
Types of Gearing Ratios
There are various types of ratios which can be used to calculate gearing. It will depend upon the objective of the analysis.
Debt to Equity Ratio
One of the easiest methods of measuring gearing is the debt-to-equity ratio.
Debt to Equity Ratio = Total Debt ÷ Shareholders' Equity
If a company has ₹80 lakh in debt and ₹160 lakh of equity, then
₹80 lakh ÷ ₹160 lakh = 0.5
It means the company has 50 paise of debt per ₹1 of equity.
Debt Ratio
It is the ratio of total debt to total assets.
Debt Ratio = Total Debt ÷ Total Assets × 100
If the total debt is ₹30 lakh and the total assets are ₹100 lakh, the debt ratio will be 30%. It means 30% of the company's total assets have been financed with debt.
| Financial Component | Amount (in Lakhs) | Ratio Breakdown |
| Total Debt | ₹30 lakh | Debt component used in numerator |
| Total Assets | ₹100 lakh | Total asset base used in denominator |
| Debt Ratio | 30% | 30% of the company’s total assets have been financed through debt |
Equity Ratio
The equity ratio measures the proportion of a company's total assets financed by shareholders' funds.
Equity Ratio = Shareholders’ Equity ÷ Total Assets × 100
The higher the equity ratio, the more the entity relies on its internal sources of funds.
Also Read More About: Ratio Analysis
Understanding High and Low Gearing
| Gearing Level | Capital Structure Balance | Key Advantages / Benefits | Primary Risks / Disadvantages |
| High Gearing | More debt relative to equity | Enables business growth, asset acquisition, and can magnify returns for stakeholders if profits outpace borrowing costs. | High financial risk; mandatory interest and principal repayments can severely strain cash flows during economic downturns. |
| Low Gearing | More equity relative to debt | Low financial risk with minimal debt-servicing pressure and greater resilience against market volatility. | Can lead to capital inefficiency and missed expansion opportunities due to underutilisation of external funding. |
Role of Gearing Ratio in Fundamental Analysis
- For comparison: The gearing ratio may be used by investors to compare different companies within the same industry. This will help investors identify companies that are relatively highly geared or ungeared.
- To analyse trends: A high gearing ratio implies that the company is becoming more indebted, while a decreasing gearing ratio indicates that the company is becoming less indebted.
- Capital structure: The gearing ratio can help investors in understanding whether the company is using debt or equity to finance its operations.
- To make investment decisions, investors can use gearing alongside profitability, cash flow, interest coverage, return on equity, and many other financial ratios.
Advantages of Gearing Ratio
- Easy to understand: The ratio provides an easy way to understand the debt-equity relationship. Anyone with basic knowledge of finance can use the ratio to determine the firm's financial structure.
- Helps measure financial risk: A high gearing ratio can imply high dependency on borrowing. It helps investors and creditors to determine the financial risks associated with the company.
- Useful for company comparison: The ratio can be used in comparing companies within the same industry. It shows the extent to which companies depend on either debt or equity.
- Helps investors in decision-making: Investors can use the gearing ratio to conduct fundamental analysis of a company's debt level relative to its performance.
- Helps management plan finance: The ratio can be useful to management in planning finance. It helps managers determine whether to pursue equity financing or debt financing.
Limitations of Gearing Ratio
- No universal ideal ratio: There is no ideal gearing ratio for all organisations. This will depend on the industry and other factors, such as size and the economic environment.
- Different calculation methods: Various organisations and analysts may use different methods to calculate gearing. Comparing ratios can be difficult when using different calculation methods.
- Does not show profitability: The gearing ratio indicates the proportion of total debt relative to equity. However, it does not indicate the organisation's profitability.
- Does not directly show cash flow: An organisation may have an acceptable gearing ratio, yet it might still experience cash flow problems. Thus, the firm's cash position should be analysed.
Conclusion
Gearing ratio measures the proportion of debt relative to shareholders' equity. A high gearing ratio means that a firm is highly dependent on borrowings and may have high financial risk. A low gearing ratio means that a firm is less dependent on borrowings. Nevertheless, high and low gearing ratios are not necessarily good or bad.
For fundamental analysis, one should compare the gearing ratio with those of similar companies and analyse its dynamics over several years. The gearing ratio should also be analysed together with profitability, cash flow, interest cover, liquidity, and other financial ratios.
