Key Financial Metrics for Investors

Gearing ratios measure a company’s capital structure by comparing debt to equity, with the debt-to-equity ratio being one of the most commonly used metrics to gauge financial health.

These ratios help investors understand how a company balances the benefits of borrowing, such as potential tax advantages, with the risks of taking on too much debt. Other gearing measures, like the times interest earned ratio, look at how easily a company can meet its debt obligations.

A company’s size and track record also matter, as larger or more established firms are often better positioned to handle higher levels of debt.

Gearing Ratios vs. Leverage: Understanding the Difference

“Gearing” refers to the use of debt. Gearing is a leverage analysis of the owner’s equity, often expressed as a ratio in financial analysis. Gearing ratios focus on leverage more than other ratios used in accounting or investment analysis. The underlying principle assumes that some leverage is good, but too much places an organization at risk.

At a fundamental level, gearing can be differentiated from leverage. Leverage refers to the amount of debt incurred to invest and obtain a higher return, while gearing compares debt with total equity—or an expression of the percentage of company funding through borrowing. This difference is found when comparing the debt ratio and the debt-to-equity ratio.

What Is the 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 unofficial standards are used among separate industries. For example, banks often have preset restrictions on the maximum debt-to-equity ratio of borrowers for different types of businesses defined in debt covenants.

A D/E ratio below 1 may be considered relatively safe, whereas values of 2 or higher might be considered risky. For example, A ratio of 1.5 indicates a company has $1.50 of debt for every $1 of equity.

The Significance of Gearing Ratios for Investors

Gearing or leverage ratios help investors understand a company’s economic health and if an investment is worthwhile or not. A company with a high gearing ratio generally has a riskier financing structure than a company with a lower gearing ratio. However, regulated entities typically have higher gearing ratios because they can operate with more debt.

Companies in monopolistic situations may operate with higher gearing ratios because their strategic marketing position puts them at a lower risk of default. Industries that use expensive fixed assets typically have higher gearing ratios because these fixed assets are often financed with debt.

The Bottom Line

Debt is inherently risky, so investors often favor businesses with lower gearing ratios, such as the debt-to-equity ratio. Lower ratios typically indicate that companies are better able to support their debt and have a reduced risk of bankruptcy during economic downturns.