Gearing Ratio 

Gearing ratios represent a set of critical financial analysis tools used to examine a firm’s financial structure and associated risk vis-à-vis its reliance on debt versus equity. The gearing ratios represent crucial information for investors, creditors, and management regarding the relative health and sustainability of a company’s financials. This article will explore gearing ratios in detail, explaining their importance, types, formulas, and practical applications. We write for the amateur reader and strive to keep this topic friendly and approachable, yet professional and authoritative. 

What is Gearing Ratios? 

Understanding Gearing Ratios 

Gearing ratios considerably reveal the company’s financial leverage by measuring the debt-to-equity ratio. These ratios are fundamentally required for checking the following aspects of a firm: 

• Risk exposure: Those firms with high gearing ratios are vulnerable during economic downturns. 

• Capital structure: A balanced capital structure often increases long-run stability. 

• Creditworthiness: Creditors use these ratios also to assess a firm’s ability to pay off its debts. 

Practical Context 

Gearing ratios are usually higher in capital-intensive industries like utilities or real estate due to the long-term use of debt to develop such investments. 

Technology companies, on the other hand, may keep their gearing ratio lower since they heavily depend on equity financing for research and development. 

Types of Gearing Ratio  

Numerous gearing ratios are used to analyse a company’s financial structure—each provides unique insight. Let’s study the most common types in detail. 

1. Debt-to-Equity Ratio (D/E)

This is the most common gearing ratio, which expresses the ratio of total debt to total equity. It determines how many debts exist for every dollar of equity shares by shareholders. 

Formula 

Debt – to – Equity Ratio = Total Debt/Total Equity 

• Total Debt: Incorporates both short-term and long-term borrowings. 

• Total Equity refers to the shareholders’ funds, with retained earnings and share capital. 

Example 

Assume the Singaporean technological company: 

Total Debt: SGX 300 million 

Total Equity: SGX 600 million 

D/E Ratio =300/600 = 0.5 

This means that for each dollar of equity, the firm has SGX of 0.50 in debt. Such a ratio reflects moderate financial leverage and manageable risk. 

2. Equity Ratio

The equity ratio measures the proportion of a company’s assets financed by shareholder equity. It provides insight into the company’s reliance on internal versus external financing. 

Formula 

Equity Ratio = Total Equity/Total Assets 

Example 

Consider another Singaporean retail firm: 

Total Equity: SGX 500 million 

Total Assets: SGX 800 million 

Equity Ratio = 500/800 = 0.625 (or 62.5%) 

This means that 62.5% of the company’s assets are financed with equity, which demonstrates a good level of financial independence. 

3. Debt Ratio

The debt ratio gives the percentage of a firm’s assets financed through debt. 

Formula 

Debt Ratio = Total Debt/Total Assets 

Example 

For the same retail company: 

Total Debt: SGX 300 million 

Total Assets: SGX 800 million 

Debt Ratio = 300/800 = 0.375 (or 37.5%) 

This means that 37.5% of the company’s assets are financed through debt, which is a balanced leverage. 

Importance of Gearing Ratios 

1. For Investors

Gearing ratios help investors know the level of risk associated with a company. A high ratio indicates increased risk, especially in volatile markets, while a low ratio suggests financial stability. 

2. For Creditors

Lenders use gearing ratios to determine whether a company is creditworthy. The lower the gearing ratio, the lower the risk of default, and thus, the company will be a safer loan prospect. 

3. For Management

Gearing ratios facilitate capital structure decision-making. Companies can decide whether to finance their operations through equity, debt, or a combination of the two based on their strategic goals and appetite for risk. 

Examples of Gearing Ratios 

Let us illustrate, using examples, how gearing ratios work in practice. 

Example 1: Technology Start-up in Singapore 

Net Debt: US$ 50 million 

Net Equity: US$ 150 million 

Calculation 

D/E Ratio =50/150 = 0.33 

This ratio value is low and indicates a high dependency on equity. This is apt for a start-up that intends to focus only on growth but without high financial risk. 

Example 2: Real Estate Company 

Net Debt: US$ 800 million 

Net Equity: US$ 200 million 

Calculation 

D/E Ratio = 800/200 = 4.0 

This high gearing ratio is common to real estate companies that use debt to fund high-value projects. However, if market conditions drastically decline, this would place them in a more vulnerable financial position. 

Example 3: Manufacturing Firm 

Equity: US$ 400 million 

Assets: US$ 600 million 

Debt: US$ 200 million 

Equity Ratio 

Equity Ratio = 400/600 = 0.67 (or 67%) 

Debt Ratio 

Debt Ratio = 200/600 = 0.33 (or 33%) 

The firm has a well-proportioned capital structure, as two-thirds of assets are financed through equity and one-third through debt. 

Frequently Asked Questions