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.
