25 February 2025
Gearing ratio: what to know for your business
6 minutes
Gearing ratio measures the debt a business uses to fund its operations against the capital it has raised. Investors and lenders usually use it to assess a company’s financial stability, i.e., how likely it is to weather an economic downturn. Business owners might also use their gearing ratio as one measure of their overall financial health.
The important thing to know is that ‘gearing ratio’ is an umbrella term that covers several different calculations, and that it’s only one metric that has to be used along with others if you want a full picture of how a company is performing.
Here, we explain what a gearing ratio is, how to calculate it, and what else to know.
What is gearing ratio?
A gearing ratio is a measure of a company’s financial leverage.
Every business will have a mix of debt (the money they’ve borrowed from lenders to finance their operations) and equity (the value of their assets or shares, depending on which formula you use to calculate the ratio). In a nutshell, the gearing ratio compares the value of the two components in this mix, and shows how the debts stack up against the equity.
This ratio is then used as a measure of how financially stable a business is.
Generally speaking, if a company is funded more by equity than by debt (i.e., they have a lower gearing ratio), that equity could be used to pay off what the company owes. This puts it in a stronger position to ride out periods of economic instability (like the one we’re all experiencing with the cost of living crisis). But, if the opposite is true, the company is more
vulnerable. This is because their higher proportion of debt will be more drastically affected by, for example, increased interest rates.
Gearing ratio can seem like a more complex calculation than it actually is because financial analysts use the term to talk about several different ways of measuring debts against assets.
For example, you might see references to a company’s:
- Debt to equity ratio
- Debt ratio
- Equity ratio
- Debt to shareholder fund ratio
All these metrics are technically ‘gearing ratios’, but depending on how a company is structured, you could perform four calculations and get four different answers.
Who uses gearing ratio metrics?
Anyone interested in a business’s financial performance, stability, or capital structure might ask about its gearing ratio.
- Lenders calculate the gearing ratio when assessing a business’s application for new credit. If the ratio is already high, lenders might be reluctant to agree to new credit because there’s a higher chance of the business defaulting on the debt – especially if the economic conditions change before the loan is repaid. Lenders can sometimes require a company to operate within a certain gearing ratio range before they sign an agreement.
- Investors examine a business’ gearing ratio to assess the risk of investing. If the ratio is higher, investors are more cautious, because they have a lower chance of seeing a return on the money they put into the business.
- Business owners and financial analysts use gearing ratios to compare the economic performances of different companies. Here, the gearing ratio can show how a company is performing in current market conditions compared to its competitors.
How to calculate gearing ratio
So, what is a gearing ratio formula?
We’re going to look at how to calculate debt to equity ratio, which is the most commonly used gearing ratio
Before you calculate gearing ratio, you need to know the business’ total long-term and short-term debts. This means finding information on business loans, vehicle or equipment financing, mortgages, overdraft, etc.
Then, to calculate the gearing ratio, divide the debt by the total equity:
Total debt / Total equity = Gearing ratio
For example, if a business has debts of £200,000 and equity of £450,000, the gearing ratio is 0.44.
Gearing ratio is often expressed as a percentage. In this case, the calculation is:
(Total debt / Total equity) x 100 = Gearing ratio
For the company described above, the gearing ratio percentage would be 44%.
If you want to look at a company’s gearing ratio from a different angle, you can substitute the total equity for a different measurement. For example, you can calculate a company’s debt ratio (which shows the extent to which a company’s assets are financed by debt) by dividing the debts by the value of the total assets and using this gearing ratio formula:
Total debts / Total assets = Debt ratio
And you can then complete the picture by calculating the corresponding equity ratio:
Total equity / Total assets = Equity ratio
Taken together, these calculations can give a fuller picture of a business’ financial stability, which lenders, investors, or owners can then use to inform their decisions.
What is a good gearing ratio?
Whether you measure it as a percentage or a fraction, a lower gearing ratio is usually better than a higher one. Put simply, the higher a business’s gearing ratio, the more vulnerable it is and the higher the risk it represents to lenders or investors.
That being said, gearing ratios don’t mean much unless you’re looking at them in context. A business’ age and its industry can have a major impact on its gearing ratio, because they can affect the business’ working capital requirements (that is, the amount of money it takes to run the company), and the amount of debt it’s still paying off.
What is a good gearing ratio? Generally, 25–50% is an average gearing ratio for a well-established company. However, this will vary from industry to industry. If you’re running a takeaway business or a joinery business, for example, your working capital requirements will be higher than a business that’s developed an app, so your gearing ratio might be higher too.
Because of this, it’s important to compare a company’s gearing ratio to other companies in the same industry. A 55% gearing ratio might sound high, but if the industry average is 60% and a competitor is operating at 70%, the first company is actually in a good position.
It’s also important to remember that financing a company’s growth with debt is not necessarily a bad thing. Sometimes, a higher gearing ratio can show that a company is invested in making its operations more profitable in the long term. This is the main reason why gearing ratios alone can’t be used to give a complete picture of a company’s financial standing – they have to be used along with other calculations and information on the business’ cash flow.
What does a gearing ratio of 0.5 mean?
A gearing ratio of 0.5 means that 50% of the company is financed by debt rather than equity.
Depending on the industry, this gearing ratio could be high, leaving the company vulnerable to spikes in interest rates. However, in some industries, and particularly for more established businesses, lenders may accept a 50% gearing ratio as a sign that a company is managing its finances well, investing in growth, and has its debt under control.
Is a 30% gearing ratio good?
A 30% gearing ratio is within the average range of 25–50%, so it will usually be seen as a healthy one. However, if this ratio is low in comparison to other companies in the industry, it can also be a sign that the company hasn’t made the most of opportunities for growth.
How to improve the gearing ratio of a business
Maybe you’ve calculated your business’ gearing ratio and it’s higher than you’d like. Maybe you’re preparing to sell your business, and you want to optimise your finances before you start talking to buyers. Either way, there are some areas where it can be possible to improve a business’ gearing ratio over time.
- Manage debt efficiently: While it’s likely that your business will always be financed by debt to a certain degree, you might be able to restructure this debt to improve your gearing ratio. For example, you could aim to renegotiate the terms of the agreements you have with lenders or pay off some of your debts. This can reduce the long-term interest you have to pay.
- Increase your company’s profits: This will increase the figure that you’re dividing the debt by and reduce the gearing ratio. Sometimes, increasing profitability means taking on more debt in the short term (for example, if you’re going to expand your product range), but this can have a positive effect on your financial stability in the long term.
- Reduce expenses and liabilities: By operating more efficiently (for example, by reducing the amount of inventory you hold and potentially reducing your storage costs in turn), you can reduce your costs and your gearing ratio.
Gearing ratio: Quick recap
Gearing ratio alone can’t measure a company’s financial success, but it can provide evidence about its ability to weather economic crises, especially in comparison to its competitors.
The more detailed your overview of a company’s assets and liabilities, the more accurate your gearing ratio calculation will be. Once you have this overview, divide the debts by the equity, multiply the answer by 100, and you’ll have a percentage you can use to measure a company’s financial stability over time.
Also read:
- Types of business insurance you should know about
- Beat the January business slowdown
- New legislation impacting your business
Are you looking for insurance cover to support your business? Get in touch with us! A member of the Howden team would love to help you find the perfect policy!