What are gearing ratios and how do you use them in trading?

What is a gearing ratio?

A gearing ratio compares the money a company has to its debt. Before we go any further, we should say that gearing ratio is a general term. There are different types of gearing ratios. But they are all based on what a company's liability is, based on where its capital (i.e. the money it uses to function) comes from. 

One common type of gearing ratio is a company’s debt-to-equity (D/E) ratio. When we’re assessing where a company gets its money from, we can look at lenders vs. shareholders. The amount of funding coming from lenders vs. the amount of money invested by shareholders is important. 

Why? Shareholders have a stake in the company and there’s no obligation for the company to repay a debt. If you buy shares in a company, you have a stake in its financial fortunes and the value of your shares is based on the value of the company. 

Money that comes from lenders is usually borrowed funds. You can liken this to a personal loan you’d get from a bank. The funding comes at a cost and that cost is the fact that a loan has to be repaid, which makes it a debt. Having debt isn’t a problem, but it can be if a company’s debt is high compared to the money it has from shareholders (aka equity). 

That’s why we need to think about the debt-to-equity ratio or, in this instance, the gearing ratio. The relationship between these two sources of funding is known as leverage. In the financial world, leverage is another word for debt (borrowed money). 

Putting all of this together allows us to measure how leveraged a company is i.e. how much debt it has compared to equity. Ideally, a company shouldn’t be over-leveraged. Having too much debt compared to equity usually isn’t ideal. Gearing ratios allow us to make this determination which then allows us to decide whether a company might be a good investment or not. 

How to calculate a gearing ratio 

We've already mentioned that there are many types of gearing ratios. We've also told you that a common type of gearing ratio is debt-to-equity. Now we need to learn how to calculate a gearing ratio. Don't worry, you don’t have to be a math genius to perform these calculations. 

The gearing ratio formula 

Long-term debt + short-term debt / shareholder equity = gearing ratio

Long-term debts are payments made over a period of more than a year e.g. loans and leases. Short-term debts typically have to be repaid in full within a year. 

If we write out the formula, we can say that a gearing ratio is the total amount of debt divided by the amount of capital provided by shareholders. 

Let’s say a company has $70,000 in long-term debt, $30,000 in short-term debt and $80,000 of shareholder equity. The gearing ratio for this company would be… 

$70,000 + $30,000 = $100,000 / $80,000 = 1.25 

We need to multiply the result of our equation to get a percentage. In this example, we get a gearing ratio of 125%. 

What is a good and bad gearing ratio? 

Once you can calculate a gearing ratio, you need to know where the percentage sits on the good and bad scale. As we’ve said, debt isn’t always a bad thing for a company. For example, a company could borrow money in order to fund an expansion project that would generate more revenue in the future, so you always have to consider gearing ratios in context. They are one aspect you can look at to evaluate the value of a company, but they're not the only thing. 

With that being said, there are commonly agreed-upon ranges for what’s considered a high, low, and optimal gearing ratio: 

• A high gearing ratio = a score above 50% 
• A low gearing ratio = a score below 25% 
• An optimal gearing ratio = a score between 25% and 50% 

How can I use gearing ratios in trading? 

Gearing ratios help us see how leveraged a company is and its financial structure. A company with a high gearing ratio will typically be using loans to cover its operational costs. This is considered a high-risk strategy because something like a change in interest rates could put the company in financial difficulty. 

A company with a low gearing ratio is, generally, more financially conservative because it’s aiming to keep debt as low as possible. One way it may be doing this is to use shareholders’ equity to cover certain costs. 

A company with an optimal gearing ratio tends to have the right balance between debt and equity. That means it’s not too exposed to economic changes because of its loans, but it’s also not too reliant on shareholders’ equity. 

What gearing ratios won’t tell you 

You can’t make definitive decisions based on gearing ratios alone. A company with a high gearing ratio might have a monopoly in its industry. Therefore, having more financial risk (i.e. debt) might not be a big issue because it basically controls the market. A company could also have a high gearing ratio because the industry they operate in is capital-intensive. That means it costs a lot to buy and run things like equipment. These companies may need to make use of loans more often. 

So, while gearing ratios are important to consider when you’re buying stocks, they shouldn’t be the only thing you focus on. What’s more, just because a company’s gearing ratio is “optimal”, that doesn’t mean it’s a sure thing. No trade is guaranteed to be profitable, regardless of a company’s gearing ratio. As long as you remember that and use this metric in conjunction with other types of analysis, you’ll be in a better position to make the decisions for your financial goals.