What is the gearing ratio?

Discover how the gearing ratio affects the ability of your small business to secure funding, investment, and manage debt.

Financing your business can feel a little like balancing spinning plates.

Picture a circus performer operating at the peak of their powers.

Whenever they’re intently focused on balancing 1 spinning plate, even for a split second too long, they run the risk of another plate crashing unceremoniously to the ground.

But when they dedicate equal time to balancing each spinning plate, they’re home and dry (and their trusty plates thank them for it).

Likewise, when you keep close tabs on your company’s debt and equity levels, you’re committed to keeping something called the gearing ratio intact, whether you realize it or not.

In this article, we walk you through what gearing is and what it’s used for, how gearing is calculated and interpreted and how your business can reduce it—increasing your company’s stability, flexibility, and financial health.

What is gearing and what is it used for?

Gearing measures a company’s financial leverage—that is, the proportion of its business funded by borrowed money (debt financing) versus the owner(s) investment or retained earnings (equity financing).

Gearing is a useful metric for lenders, investors, and small business owners alike.

It provides insights into a company’s risk level, which help lenders assess a borrower’s ability to repay debt.

Gearing also helps investors determine whether to invest in a particular company (or not touch it with a 10-foot pole).

And small business owners can use it to analyse their cash flow and decide if they need to reduce their borrowing.

How to calculate the gearing ratio

There are a number of ways to work out your gearing, but here are the 3 most commonly used methods.

1. Debt-to-equity ratio

The most popular formula is the debt-to-equity ratio, which shows how much debt your company uses to finance the business rather than using its own money.

Take your company’s total debt—short-term debt plus long-term debt—then divide it by its shareholder equity.

If you prefer the debt-to-equity ratio as a percentage, multiply it by 100.

The formula looks like this:

(Short-term debt + long-term debt) / shareholder equity

2. Debt ratio

Another popular formula is the debt ratio, which measures the proportion of your company’s assets financed by debt.

Divide your company’s total debt by its total assets.

Again, if you would like the debt ratio as a percentage, multiply it by 100.

Here’s the equation:

Total debt / total assets

3. Equity ratio

A third formula is the equity ratio, which is the proportion of your company’s assets funded by equity.

Divide your company’s total equity by its total assets.

For an equity ratio expressed as a percentage, multiply it by 100.

This is the calculation:

Total equity / total assets

Regardless of the gearing formula you use, you’ll get a good idea of how well your company will be able to satisfy its financial obligations during economic fluctuations.

How to interpret the gearing ratio

High gearing (above 0.5 or 50%) means your company has a lot of financial leverage, so it heavily relies on debt to pay for day-to-day operations, which is, quite literally, risky business.

During an economic downturn, your company may have difficulty maintaining its debt repayment schedule, which could, in turn, put it at risk of default and even insolvency.

But not all companies with high gearing are created equal.

For instance, a company with high gearing operating in a capital-intensive sector, such as the car industry, or a regulated sector, such as utilities, isn’t necessarily in poor financial shape because high gearing is typical in these industries.

Equally, companies with low gearing aren’t created equal either.

Although low gearing (below 0.25 or 25%) suggests a company is using more equity than debt to finance the business, it can also mean the company can’t capitalize on debt financing to expand it.

Ideal gearing is between 0.25 (25%) and 0.50 (50%), which indicates a healthy balance between equity and debt financing.

For a more complete picture of your company’s financial condition, it’s important to contextualize gearing.

In other words, your company’s ratio should be benchmarked against the ratios of other companies in the same industry.

How to use the gearing ratio: An example

Let’s look at how your small business can benefit from calculating its gearing.

For the purposes of this illustration, we’ll call your fledgling accountancy practice, A-Star Accounting (ASA).

Rumour has it that accountants are flocking in their droves to join ASA, so you’re hellbent on opening a second location.

But you need more funds to hire staff, buy equipment and lease extra office space.

You can either apply for debt financing, such as a bank loan, equity financing (investment), or both.

By calculating ASA’s gearing, you evaluate the financial risk attached to securing more debt.

If it’s high (above 0.5), which indicates heavy debt reliance, you might want to reconsider applying for a bank loan and consider the equity route instead.

But if gearing is less than 0.25, for example, this suggests ASA is less dependent on borrowing to finance the business, which makes taking on additional debt far less risky.

How to reduce the gearing ratio

Larry Hartman, Chief Strategic Officer at PixelFree Studio, a software solution company, shares some first-hand experience of reducing his company’s gearing.

“In PixelFree’s growth phase, we focused on equity financing to keep our gearing in a safe range,” he says.

“Exploring equity financing options, like getting investors onboard, can help your balance sheet without adding to your debt.

“It certainly helped us grow without taking on too much debt, which is important for long-term success, because it kept our finances stable.”

Larry recommends companies reinvest profits in the business rather than take out more loans.

“To do this, cut unnecessary costs and, to make more money, focus on providing goods or services with high margins,” he says.

Other ways to reduce your gearing include:

• Paying off long-term debt to reduce interest payments.
• Refinancing debt to take advantage of lower interest rates or longer repayment terms.
• Selling non-essential assets to increase cash reserves and pay down more debt.

Final thoughts

Gearing is a little metric that goes a long way towards letting lenders and investors know the financial health of your company.

It’s also a big boon for your business analysis.

By keeping a close eye on your gearing, you’ll not only be better positioned to weather any financial storms that come your way, but you’ll also be better informed if or when your business sparks any investor interest.