What Is a Gearing Ratio?

What Does Gearing Ratio Mean, and How is it Calculated?

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A gearing ratio is a financial ratio that compares owner's equity to borrowed funds. Investors sometimes use it to assess how well a company may survive an economic downturn. 

The Relationship Between Financial Leverage and Financial Risk

Financial leverage is the use of borrowed money to increase sales volume, thereby increasing profit. A business owner, for instance, may increase financial leverage with a bank loan that allows him to buy more production machinery.

 

Financial risk is a broader term that includes the added risk of default when a company expands using financial leverage, but may also include other forms of risk not directly related to gearing ratios, such as investments in other companies. 

Although financial leverage and financial risk are not one and the same thing, they're related. Measuring the degree to which a company uses one common form of financial leverage -- running a business with borrowed funds -- provides an easily calculated way of assessing a company's financial risk.

Calculating the Gearing Ratio

The gearing ratio is a broad term that describes financial leverage. The term is often used to describe the ratio between the company's debt and shareholder (or owner's) equity. Another related gearing ratio is the long-term debt to total capitalization ratio, which eliminates short-term debt obligations from the equation and substitutes for owner's equity the company's total capitalization, a more volatile financial parameter.

 In practice, most discussions of gearing ratios describe the degree of leverage by comparing all company debt to shareholder equity: 

                  Gearing ratio = company debt ÷ shareholder equity

Shareholder equity is the company's book value. In theory, the book value is the present value of all tangible assets, such as its physical plant, land and machinery.

Both stockholder equity and company debt can be found in the company's 10-k report, the SEC required annual report to shareholders.

If, for example, a company's book value were $200 million and it had $70 million in debt, the gearing ratio would be 70/200 or 35 percent. This particular ratio is neither good nor bad. It typifies the gearing ratios of many public companies. A gearing ratio of more than 50 percent, however, is considered high.

The Gearing Ratio as a Financial Risk Indicator

The borrowing practices of private equity companies provide clear examples of the upside and downside of high gearing ratios. 

Private equity companies often use partially borrowed funds to finance their corporate acquisitions. A portion of the money to buy (or takeover) another company comes from the private equity firm itself. The rest of the money typically comes from debt the private equity firm takes out against the assets of the company being acquired. Inevitably, the gearing ratio rises in the process.

The advantage of this rise in the debt to equity ratio of the acquired company is the private equity firm's increased profit when the company is resold or once again becomes a public company. If a private equity company finances a corporate acquisition with its own funds and later sells the company for a 30 percent profit, it's received a 30 percent return on its investment.

If, on the other hand, it finances the acquisition by splitting the acquisition funds equally between its own capital and the borrowed capital of the acquired company, selling the company for 30 percent more than the price of acquisition provides a 60 percent profit on investment. This is a powerful incentive to raise the gearing ratio. From 2007 through 2012, private equity companies made their acquisitions with an average gearing ratio of 58 percent, thusly significantly increasing their returns on investments. 

When leveraged buyouts run into trouble, however, their high gearing ratios often ensure the company's liquidation in bankruptcy. High gearing ratios increase financial risk. An academic study of 48 leveraged buyouts -- buyouts, in other words, with high gearing ratios -- concluded that 20 of them eventually filed for bankruptcy protection.

In finance as in life generally, there is no free lunch.