Gearing Ratio vs. Debt-to-Equity Ratio: An Overview
Gearing ratios form a broad category of financial ratios, of which the debt-to-equity ratio is the predominant example. Accountants, economists, investors, lenders, and company executives all use gearing ratios to measure the relationship between owners' equity and debt. You often see the debt-to-equity ratio called the gearing ratio, although technically it would be more correct to refer to it as a gearing ratio.
All companies have to balance the advantages of leveraging their assets with the disadvantages that come with borrowing risks. This same uncertainty faces investors and lenders who interact with those companies. Gearing ratios are one way to differentiate financially healthy companies from troubled ones.
Key Takeaways
Gearing ratios constitute a broad category of financial ratios, of which the debt-to-equity ratio is the best example.
Accountants, economists, investors, and other financial professionals use gearing ratios, as they provide a means of measuring the relationship between owners' equity and debt.
Gearing ratios are a tool for separating financially healthy companies from troubled ones.
Understanding Gearing Ratio
"Gearing" simply refers to financial leverage. Gearing ratios focus more heavily on the concept of leverage than other ratios used in accounting or investment analysis. The underlying principle generally assumes that some leverage is good, but too much places an organization at risk.
At a fundamental level, gearing is sometimes differentiated from leverage. Leverage refers to the amount of debt incurred for the purpose of investing and obtaining a higher return, while gearing refers to debt along with total equity—or an expression of the percentage of company funding through borrowing. This difference is embodied in the difference between the debt ratio and the debt-to-equity ratio.
Put another way, leverage refers to the use of debt. Gearing is a type of leverage analysis that incorporates the owner's equity, often expressed as a ratio in financial analysis.
Gearing and leverage can often be used interchangeably. Europeans tend to talk about gearing (especially in British English/finance) while Americans refer to it as leverage.
Understanding Debt-to-Equity Ratio
The debt-to-equity ratio compares total liabilities to shareholders' equity. It is one of the most widely and consistently used leverage/gearing ratios, expressing how much suppliers, lenders, and other creditors have committed to the company versus what the shareholders have committed. Different variations of the debt-to-equity ratio exist, and different unofficial standards are used among separate industries. Banks often have preset restrictions on the maximum debt-to-equity ratio of borrowers for different types of businesses defined in debt covenants.
Special Considerations
Debt-to-equity ratio values tend to land between 0.1 (almost no debt relative to equity) and 0.9 (very high levels of debt relative to equity). Most companies aim for a ratio between these two extremes, both for reasons of economic sustainability and to attract investors or lenders. Debt-to-equity, like all gearing ratios, reflects the capital structure of the business. A higher ratio is not always a bad thing, because debt is normally a cheaper source of financing and comes with increased tax advantages.
The size and history of specific companies must be taken into consideration when looking at gearing ratios. Larger, well-established companies can push their liabilities to a higher percentage of their balance sheets without raising serious concerns. Companies that do not have long track records of success are much more sensitive to high debt burdens.
The Debt to Equity ratio (also called the “debt-equity ratio”, “risk ratio”, or “gearing”), is a leverage ratio
leverage ratio
A leverage ratio is any kind of financial ratio that indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement.
Leverage refers to the amount of debt incurred for the purpose of investing and obtaining a higher return, while gearing refers to debt along with total equity—or an expression of the percentage of company funding through borrowing.
Loan To Value or LTV is a ratio of a company's debts to its total assets.It differs from gearing, which is a measure of a company's debts to its net assets.
The term capital gearing refers to the ratio of debt a company has relative to equities. Capital gearing represents the financial risk of a company. It is also referred to as financial gearing or financial leverage.
Total debt-to-total assets is a leverage ratio that shows the total amount of debt a company has relative to its assets. The debt-to-equity (D/E) ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders' equity.
It is calculated by dividing total debt by total equity. This ratio provides insight into a company's financial leverage and risk. On the other hand, the capital gearing ratio measures the extent to which a company's operations are funded by long-term debt compared to equity.
The gearing ratio is an indicator of the financial risk associated with a company. If a company has too much debt, it has the potential to fall into financial distress. Remember: A high gearing ratio shows a high proportion of debt to equity, while a low gearing ratio shows the opposite.
The Debt to Equity ratio (also called the “debt-equity ratio”, “risk ratio”, or “gearing”), is a leverage ratio that calculates the weight of total debt and financial liabilities against total shareholders' equity. Unlike the debt-assets ratio which uses total assets as a denominator, the D/E Ratio uses total equity.
A business with low gearing is one that is funded mostly by share capital (equity) and reserves, while a business with high gearing is mainly funded by loan capital. Liquidity refers to how quickly an asset can be converted into cash. Money in the bank, or held in cash, is the most liquid asset.
Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.
The debt to equity ratio can be converted into a percentage by multiplying the fraction by 100. This is perhaps an easier way to understand the gearing of a company and is generally common practice.
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.
A good current ratio is between 1.2 to 2, which means that the business has 2 times more current assets than liabilities to covers its debts. A current ratio below 1 means that the company doesn't have enough liquid assets to cover its short-term liabilities.
The debt ratio, also known as the “debt to asset ratio”, compares a company's total financial obligations to its total assets in an effort to gauge the company's chance of defaulting and becoming insolvent.
A high debt-to-equity ratio indicates that a company is borrowing more capital from the market to fund its operations, while a low debt-to-equity ratio means that the company is utilizing its assets and borrowing less money from the market. Capital industries generally have a higher debt-to-equity ratio.
The debt-to-equity ratio (D/E ratio) depicts how much debt a company has compared to its assets. It is calculated by dividing a company's total debt by total shareholder equity.
Borrowing to invest, also known as gearing or leverage, is a risky business. While you get bigger returns when markets go up, it leads to larger losses when markets fall. You still have to repay the investment loan and interest, even if your investment falls in value.
A business with low gearing is one that is funded mostly by share capital (equity) and reserves, while a business with high gearing is mainly funded by loan capital. Liquidity refers to how quickly an asset can be converted into cash. Money in the bank, or held in cash, is the most liquid asset.
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