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.
FAQs
Both the debt-to-equity ratio and gearing ratio are used to evaluate a company's financial health. The debt-to-equity ratio measures the amount of debt a company holds compared to its equity. The gearing ratio is more focused on leverage.
What is the difference between gearing ratio and debt to equity ratio? ›
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.
What is the difference between debt ratio and debt to equity ratio? ›
The key difference between debt ratio and debt to equity ratio is that while debt ratio measures the amount of debt as a proportion of assets, debt to equity ratio calculates how much debt a company has compared to the capital provided by shareholders.
What is the difference between gearing ratio and net gearing ratio? ›
A gearing ratio is a general classification describing a financial ratio that compares some form of owner equity (or capital) to funds borrowed by the company. Net gearing is the most common type of gearing ratio and is calculated by dividing the total debt by the total shareholders' equity.
What is the difference between liquidity ratios and gearing ratios? ›
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.
What is the difference between debt and equity? ›
"Debt" involves borrowing money to be repaid, plus interest, while "equity" involves raising money by selling interests in the company. Essentially you will have to decide whether you want to pay back a loan or give shareholders stock in your company.
What is the difference between debt ratio and debt to total assets ratio? ›
The debt ratio, or total debt-to-total assets, is calculated by dividing a company's total debt by its total assets. It is also called the debt-to-assets ratio. It is a leverage ratio that defines how much debt a company carries compared to the value of the assets it owns.
What is the difference between debt-to-equity ratio and debt to market cap ratio? ›
Debt-to-Equity Ratio = Total Debt / Total Equity. Debt-to-Capital Ratio = Total Debt / (Total Debt + Total Equity) Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)
What is the difference between the debt ratio and the debt payment ratio? ›
The difference between your debt-to-income and debt-to-credit ratios is that DTI compares your monthly debt payments to your income, while your debt-to-credit ratio compares your monthly debt payments to your total available credit.
What is the difference between leverage ratio and gearing ratio? ›
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.
Gearing is the amount of debt – in proportion to equity capital – that a company uses to fund its operations. A company that possesses a high gearing ratio shows a high debt to equity ratio, which potentially increases the risk of financial failure of the business.
Is gearing ratio good or bad? ›
As a result, a high gearing ratio generally indicates a higher level of financial risk for the company. On the other hand, a low gearing ratio indicates that a smaller proportion of the company's capital structure is funded by debt, which means the company is less vulnerable to financial risks.
What is another name for the gearing ratio? ›
The gearing ratio is often used interchangeably with the debt-to-equity (D/E) ratio, which measures the proportion of a company's debt to its total equity.
What is the difference between equity ratio and gearing ratio? ›
One way to understand how a company is financed is to assess its total debt to equity ratio. Also called a gearing ratio, this is the amount of debt vs. equity that a company uses to finance its operations. A gearing ratio therefore allows the respective weight of total financial debt and equity to be assessed.
What is the difference between debt ratio and liquidity ratio? ›
In contrast to liquidity ratios, solvency ratios measure a company's ability to meet its total financial obligations and long-term debts. Solvency relates to a company's overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current or short-term financial accounts.
What is the meaning of 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. Note a higher debt-to-equity ratio states the company may have a more difficult time covering its liabilities.
Is gearing ratio the same as LTV? ›
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.
Is capital gearing the ratio of debt to equity? ›
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.
