Leverage and Gearing Ratios: Complete Guide

Meaning | Examples | Formula | Calculation | Interpretation | Good/Bad | Low/High

Emilie N.- FCCA, CB, MBS
Emilie N.- FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from corporates, financial services firms - and fast growing start-ups.

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Contents

Explanation: What Do Gearing & Leverage Mean?

Gearing & Leverage: Risk/Growth
Capital Structure HIGH Gearing LOW Gearing
Debt High Low
Equity Low High
Financial Risk Higher Lower
Growth Opportunity Higher Lower

Financial gearing, or leverage, is the use of debt–as opposed to equity–for the purpose of business financing, with the aim that the return generated will exceed the borrowing costs.

However, leverage can have the opposite effect and amplify losses if the rate of return does not offset the financing costs of servicing the debt.

As a result, having gearing in a company’s capital structure adds risk but it can also magnify gains if the borrowed funds are well utilized.

In other words, leverage and gearing ratios measure the financial risk of a company's capital structure.

Capital structure refers to the way an entity is financed in terms of the proportion of debt (capital contributed by creditors; e.g., funds borrowed from lenders) to equity (capital contributed by owners; e.g., funds from shareholders):

While excessive debt can lead to financial difficulties and companies with low gearing ratios are generally considered more financially sound, the use of debt financing does not automatically raise a red flag.

In fact, debt is typically cheaper than equity and it also reduces the amount of money that shareholders need to invest into a business. When invested properly (i.e., return on investment is higher than the cost of debt), leverage can help boost profits.

Hence, a company that never uses leverage is likely missing out on an opportunity to grow its business by taking advantage of debt financing. This is especially true when interest rates are low and the business enjoys healthy and predictable cash flows.

Keep reading to find out how to calculate, interpret and use leverage and gearing ratios to your advantage >>>

Users: Who Uses Gearing & Leverage (and Why)?

Lenders

Financial institutions and other creditors primarily use gearing and leverage ratios to determine a borrower’s ability to repay a loan in order to:

  • decide whether or not to extend credit
  • draft the terms and conditions of a proposed loan (e.g., collateral security required, level of leverage permitted)

Investors

Investors assess gearing and leverage ratios to determine if a business is a viable investment when deciding:

  • whether or not to invest in a company
  • the amount of financing to offer and the level of return to demand

Internal Management

For the company itself (e.g. financial managers within the business), gearing and leverage ratios are a useful way to:

  • monitor leverage to manage debt levels
  • make financing decisions
  • forecast future cash flows and profit

Calculation: What Is the Leverage & Gearing Ratio Formula?

Gearing & Leverage Calculation: Common Formula Variations
Debt Equity Gearing Total or Capital Gearing
Long-term Debt Long-term Debt ÷ Equity Long-term Debt ÷ (Debt + Equity)
Total Debt (Long-term Debt + Short-term Debt) ÷ Equity (Long-term Debt + Short-term Debt) ÷ (Debt + Equity)

Gearing and leverage can be calculated in a number of ways, including the two most commonly used methods below:

1. “Equity” Gearing = Debt ÷ Equity

2. "Total” Gearing or “Capital” Gearing = Debt ÷ (Debt + Equity)

In practice, the Total or Capital Gearing formula is usually used more often than Equity Gearing.

What exactly do you need to include in the gearing/leverage calculation? >>>

Equity

  • Common ordinary share capital = Owners’ or Shareholders’ equity
  • Reserves = retained earnings
  • Non-controlling interest = minority interest

Debt

The gearing/leverage formula typically includes either total borrowings or long-term borrowings only:

1. Long-term Debt

This variation is useful when most of a company’s debt is long-term, but not when a company has a large amount of short-term debt (e.g., when creditors are not willing to extend long-term lending to the company).

2. Total Debt

Total Debt = (Long-term debt + Short-term debt + Other debt obligations)

This is the most comprehensive form of the gearing/leverage ratio, which comprises all types of non-current as well as current debt

Note that not all liabilities are regarded as debt for the purpose of the gearing/leverage calculation, for example:

Debt in Gearing/Leverage Ratio Calculations
Debt Not Debt
Include in Gearing Calculation Exclude from Gearing Calculation
Line of credit (e.g., bank overdraft, loan, mortgage) Deferred revenue
Leases (e.g., capital lease) Accounts payable
Notes payable (including the current portion maturing in <1 year) Accrued expenses
Bonds payable (<1 year and >1 year) Dividends payable

Preference share capital is typically treated as debt rather than equity because it has the priority right to the receipt of interest, dividends or any other claim on distributable earnings before ordinary shareholders.

Nevertheless, sometimes, non-redeemable preference shares (less common than redeemable) are still classified as equity.

Equity + Debt

= Total Capital Employed

The ratio is usually converted into a percentage by multiplying the fraction by 100, because it makes it easier to express how much of a company’s equity would be required to pay off its debt.

Alternative Formulas: Gearing & Leverage Calculation Variants

Below are a few of the ratios most commonly used to measure the debt load of a company that fall under the umbrella category of financial leverage and gearing:

Debt, Gearing & Leverage: Ratio Alternatives (Examples)
Ratio: Also known as: Formula:
Debt
Debt ratio debt-to-assets Debt ÷ Assets
Debt-to-earnings debt-to-EBITDA (earnings before interest, taxes depreciation and amortization) Debt ÷ Earnings
Equity
Equity ratio equity-to-assets Equity ÷ Assets
Equity multiplier assets-to-equity Assets ÷ Equity
Interest
Interest cover ratio interest coverage Operating Profit ÷ Debt Interest
Interest gearing ratio n/a (inverse interest cover) Debt Interest ÷ Operating Profit
Debt service coverage ratio DSCR (debt service = principal + interest) Operating Profit ÷ Total Debt Service
Gearing & Leverage
Equity gearing & leverage ratio debt-to-equity, D/E Debt ÷ Equity
Capital or Total gearing & leverage ratio debt-to-capital Debt ÷ (Debt + Equity)

This article focuses primarily on the last two ratios, i.e., equity gearing (debt-to-equity) and capital gearing (debt-to-capital).

Since there are so many variations of the gearing/leverage ratios, always make sure that you are comparing apples-to-apples by clarifying that the ratios have been calculated on a consistent basis.

Examples: How Is Gearing & Leverage Ratio Calculated?

Question:

Calculate the gearing/leverage ratio for Company A based on the extract from its financial statements below:

Question: Gearing & Leverage Ratio - Calculation Example
Balance Sheet Company A
Short-term borrowings $10,000
Notes payable $20,000
Long-term debt due within 1 year $30,000
Total Short-term Debt $60,000
Long-term capital lease $20,000
Bonds payable $40,000
Other long-term debt obligations $60,000
Total Long-term Debt $120,000
Total Debt $180,000
Common stock $100,000
Retained earnings $80,000
Total Equity $180,000

Answer:

Let’s calculate the gearing/leverage ratio with the four most commonly used formulas:

  1. Equity gearing using total debt and long-term borrowings only
  2. Total capital gearing, also using total debt and long-term borrowings only

1. Equity Gearing & Leverage

Answer Solution: Gearing & Leverage Ratio - Calculation Example
EQUITY Gearing & Leverage
Long-term Debt = Long-term Debt ÷ Equity
$120,000 ÷ $180,000 = 0.67 or 67% For every $1 in equity, Company A has 67 cents in leverage.
Total Debt = (Long-term Debt + Short-term Debt) ÷ Equity
($120,000 + $60,000) ÷ $180,000 = 1.00 or 100% or 1 times A ratio of 1 implies that creditors and investors are on equal footing in Company A’s capital structure as for every $1 of Company A owned by its shareholders, Company A owes $1 to creditors.

2. Total/Capital Gearing&Leverage

Answer Solution: Gearing & Leverage Ratio - Calculation Example
TOTAL (or CAPITAL) Gearing & Leverage
Long-term Debt = Long-term Debt ÷ (Debt + Equity)
$120,000 ÷ ($180,000 + $180,000) = 0.33 or 33% One third of Company A’s capital is comprised of debt, while 2/3 belong to the company’s shareholders.
Total Debt = (Long-term Debt + Short-term Debt) ÷ (Debt + Equity)
($120,000 + $60,000) ÷ ($180,000 + $180,000) = 0.50 or 50% 50% gearing ratio means that for every $1 in shareholder equity, Company A has 50 cents (i.e., exactly half) of debt financing.

Are you wondering if the ratios we’ve just calculated are high/low and good/bad?

You’re 100% correct – a ratio is virtually meaningless until it is evaluated in context.

Keep reading as the next part of this article explains how to do just that – analyze and interpret gearing & leverage ratios >>

Good/Bad: What Is a Good Leverage & Gearing Ratio?

Although there is no absolute guide to what an ideal gearing ratio should be, a general rule of thumb suggests minimum 25% and maximum 50% leverage ratio as a safe benchmark.

In practice, many companies operate successfully with a higher leverage and gearing ratio than this, but 50% is nonetheless a helpful benchmark.

Ideal Gearing & Leverage Ratio: High or Low?
Ratio High/Low Explanation
>100% Very High A gearing/leverage ratio above 1.0 indicates that a company has more debt than equity.
=100% Very High A gearing/leverage ratio of 1.0 indicates that a company has as much debt as it has equity.
>50% High A gearing/leverage ratio that exceeds 0.50 typically represents a highly geared/leveraged company that is at a greater risk of insolvency, loan default and financial failure.
25%-50% Normal A gearing/leverage ratio between 0.25 and 0.50 is generally considered optimal.
=50% Normal A ratio of 0.50 indicates that a company has twice as much equity as it has debt.
<25% Low A gearing/leverage ratio lower than 0.25 is usually considered low-risk.
<10% Very Low A gearing/leverage ratio below 0.10 indicates that a company has almost no debt relative to equity.

Therefore, if the ratio is over 50% and worsening, a company’s debt position would be worth examining, because leverage and gearing indicate the risk attached to the entity’s finance.

High/Low Leverage: Is High or Low Gearing Better?

It is important to remember that although companies with higher gearing ratios generally carry more risk, high financial leverage does not necessarily indicate financial distress.

Leverage and gearing are good when a company uses debt finance so that the return generated is greater than the cost of servicing the debt. If the return on borrowed funds is lower than the cost of servicing the debt, then leverage/gearing is too high and reduces the return on equity.

In other words, excessive and uncontrolled debt levels can be risky for a company and its investors. On the other hand, if a company’s is able to generate a higher rate of return than the interest paid on its loans, then the debt can help to accelerate profitability and business growth.

High Gearing: Advantages

In many cases, having debt on the balance sheet is a smart strategic business decision, including the following 5 instances:

1. ROE Increase

High leverage and gearing ratio can be beneficial when a company is using the borrowed funds to increase its return on equity (ROE) and is able to comfortably service the debt obligations with the ongoing cash flows from the rising revenue income.

As such, the use of debt financing can accelerate business growth and support long-term profitability (e.g., expansion into new markets, mergers & acquisitions, improvement of business offering, development of new products/services).

2. WACC Decrease

The cost of debt is typically lower than the cost of equity. Therefore, the higher the proportion of debt to equity, the lower a company’s weighted average cost of capital (WACC). Naturally, this only works up to a certain point.

3. Cash Flow

When a company that is otherwise financially sound experiences a temporary cash flow shortfall (e.g., due to seasonal cyclicality), it can take advantage of the many debt financing options readily available from financial institutions and other lenders for that exact purpose.

For example, agricultural companies often need to borrow money on short-term basis as the industry is affected by seasonal demand.

4. Investment Capital

As long as the borrower meets their requirements, lenders may promptly provide funding for significant time-sensitive investments that would be challenging to finance from shareholders’ equity due to the time constraints (e.g., acquiring assets of a competitor that is exiting the market).

5. Share Dilution

Debt financing allows a company to raise new capital to support its operations without affecting the ownership composition of the business.

Many shareholders prefer sourcing capital from debt rather than equity as issuing more shares of stock can dilute their ownership stake in the company.

6. EPS Increase

As a company optimizes the use of gearing/leverage for maximum profitability and minimal use of equity to run its operations, shareholders benefit from the increase in both ROE (return on equity) as well as EPS (earnings per share).

High Gearing: Disadvantages

All things being equal, a company with a higher level of gearing/leverage faces increased financial risk in terms of variability of returns to shareholders, long-term liquidity and ultimately the ability to remain in business.

1. Risk

A high gearing ratio means that a company is using a lot of of leverage to finance its operations, which can multiply both the income as well as the risk of the business.

When a company’s debt load is too high relative to its assets, the burden of debt principal and interest repayments takes up such a significant portion of cash flows that even a relatively small financial performance issue could result in the business not being able to generate enough cash to pay back its debt obligations.

This is also why high gearing/leverage ratios may prevent a company from attracting additional capital as creditors and shareholders are less protected in the event of a financial decline or liquidation–and so less likely to recuperate their money.

2. Volatility

The more geared/leveraged a company is, the greater the risk of volatility of earnings available to distribute by way of dividend to the ordinary shareholders.

High levels of gearing and leverage indicate that a company relies heavily on debt to finance its long term needs, which increases the level of risk for the company’s common ordinary shareholders.

Why? Because the interest and capital repayments on debt must be made regardless of the company’s profits, whereas there is no obligation to make payments to equity.

Hence, a highly geared company must earn enough profit to first cover its payments to holders of debt before anything is available for distribution to the holders of equity (e.g., dividends).

On the other hand, if the borrowed funds are invested in initiatives that provide returns in excess of the cost of debt capital, then shareholders will enjoy increased returns on their equity.

Therefore, this leads to greater volatility in dividends paid to shareholders where a company is highly geared.

3. Insolvency

The more geared/leveraged a company is, the greater the probability of financial failure occurring as a result of its inability to service debt and raise capital.

Ultimately, gearing and leverage ratios measure a company’s ability to remain in business because high proportion of debt to equity can cause:

  • High susceptibility to unfavorable financial circumstances, such as economic downturn, increase in variable interest rates or trading difficulties that less-geared company might survive.
  • Issues with servicing existing debt as high amounts of interest have to be paid back to lenders regardless of whether a company is generating income or not.
  • Credit downgrades resulting from a company defaulting on its debt obligation.
  • High cost of debt as lenders cover themselves against the higher risk of their loans not being repaid.
  • Restrictive covenants imposed by creditors (e.g., forcing borrowers to direct all cash into debt repayment instead of business growth; or realize secured assets to pay interest if funds are unavailable from other sources).
  • High cost of equity as investors are reluctant to come onboard or provide more equity finance.
  • Fall in share price as the above factors are undermining the stock market’s confidence in the company.
  • Higher risk of entering liquidation if a company that borrowed too much money cannot pay back its debt obligations.

Low Gearing: Advantages

Lower leverage and gearing ratios tend to be more desirable for companies as well as their investors because they generally indicate lower financial risk associated with better debt management and financial stability, as reflected in:

  • Principal and interest debt repayments commanding only a reasonable portion of a company’s cash flows so it is not too sensitive to changes in business and economy (e.g., business or economic downturn, rise in interest rates).
  • Sufficient revenue being generated to fund a company’s assets, operations and growth though profits.
  • Creditors’ interests being more protected in case of a company’s decline or failure.
  • Shareholders being more likely to get their original investment back in the event of a liquidation.

Nevertheless, not all debt is bad debt and a low leverage/gearing ratio does not necessarily mean that a company’s capital structure is healthy. Quite the opposite, in fact. >>>

Low Gearing: Disadvantages

A low gearing ratio is typically indicative of:

  • Conservative financial management where shareholders’ equity rather than debt is primarily used to pay for business expenses.
  • A company operating in a cyclical industry, which is more sensitive to seasonality and economic cycles, making an effort to limit its exposure to debt as it cannot afford to become overextended in the face of an inevitable downturn in sales.

Therefore, the main issue with low leverage ratios is that the companies that rarely borrow do not take full advantage of cheaper forms of financing as a means of responsibly growing their business and boosting earnings, ultimately missing out on opportunities that their competitors may take.

Interpretation: What Is an Ideal Leverage & Gearing Ratio?

No one single metric provides a comprehensive view of a company’s financial health. Likewise, the gearing ratio is just a small piece of the big puzzle.

Hence, the optimal level of leverage for a company should be determined by considering many factors, including:

  • Industry averages and benchmarks
  • Competitors
  • Other comparable companies
  • The company’s own historical performance and strategy

1. Industry

Healthy levels of gearing and leverage vary wildly between industries.

For example, high ratios can often be found in industries that are:

  • Capital-intensive: Companies in industries that require large capital expenditures (CapEx), such as manufacturing, typically have high gearing ratios because they tend to finance their significant fixed asset needs with debt.
  • Regulated: Companies in mature and regulated industries with high barriers to entry and a few competitors (e.g., monopoly or duopoly), such as utilities, can afford to operate with higher debt levels because the financial risk is mitigated by their strong position.

Conversely, a high ratio could be risky in an industry with:

  • Fast-changing competitive landscape and market share
  • Short product cycles
  • Volatile cash flows

Hence, gearing ratios are usually used as a tool to compare financial leverage of similar companies within one industry sector.

For instance, a company with a gearing ratio of 60% could be regarded as high risk when evaluated in isolation. However, when compared to its key competitor that reports leverage of 70% and the industry average of 75%, the company’s debt levels appear more satisfactory.

2. Company Performance

Even within the same industry, a safe gearing ratio can vary from company to company, depending on the ability of a business to manage its debt, as signalled by indicators including:

  • Cash flows
  • Profit margins
  • Revenue growth
  • Market share

For example, a start-up with unpredictable cash flows is able to handle much lower level of gearing than a well-established mature corporation that continuously generates strong reliable cash flows and could easily pay off its debt by issuing equity if needed.

Similarly, the use of leverage is beneficial when a company enjoys strong and stable cash flows as the income becomes amplified. However, when experiencing a decline in profitability, a highly geared company is at a higher risk of default than a less geared one in the same situation.

3. Company Strategy

There are several situations when companies deliberately take on financial gearing to strengthen their capital structure, some of which include:

  • Raising funds without dilution of equity shares
  • Sourcing capital for large and time-sensitive investments
  • Covering short-term operational cashflow shortfalls

How to Improve Gearing & Leverage Ratio?

Companies have a number of debt and equity management methods at their disposal to improve the capital structure of a business and its leverage/gearing ratio, such as:

1. Manage Debt

Companies can take several steps to reduce their leverage/gearing ratio, such as :

  • Pay off debt
  • Renegotiate debt terms
  • Avoid taking out more loans

2. Issue Shares

Raising equity capital by issuing more shares can also decrease a company’s gearing ratio.

3. Convert Loans

Furthermore, companies can negotiate with their lenders to convert any existing debt into equity shares.

4. Reduce Costs

Expense reduction will lower the gearing ratio by decreasing liabilities through:

  • Increasing operational efficiency
  • Introducing more cost control measures
  • Identifying areas of improvement to cut costs

5. Reduce Working Capital

Moreover, a company can free up additional cash to pay down debt by reducing the amount of money tied up in its working capital:

  • Decrease the number of days required to collect accounts receivable
  • Increase the number of days required to pay for accounts payable
  • Reduce and optimize the required inventory levels

6. Improve Profits

Another method to decrease a company’s leverage/gearing ratio is to increase its revenue, profits and retained earnings, which can help to:

  • Generate more cash with which the company can pay its debts
  • Increase stock price and, in turn, shareholder equity

Conversely, a company can increase its leverage/gearing ratio in many ways, including:

  1. Buy back ordinary common shares
  2. Pay dividends out of reserves
  3. Issue financials instruments classified as debt (e.g., bonds)
  4. Reinvest revenue into operations and business growth

Gearing vs. Leverage: What’s the Difference?

The term “leverage” can either be used interchangeably with the word “gearing” or differentiated as follows:

Gearing vs. Leverage: What’s the Difference?
Knowledge Domain Leverage: Alternative Uses
Finance - Gearing: Identical Meaning Leverage is an alternative and synonymous term for gearing, where the two words have the same meaning and are used interchangeably.
“Leverage” tends to be used more frequently in the United States, while “gearing” is more common in the United Kingdom and Australia.
Finance - Gearing: Converse Meaning Leverage also describes the converse of gearing and is used to measure the proportion of capital or assets financed by equity (leverage), as opposed to debt (gearing).
Example - Total (or Capital) Gearing and Leverage ratios:
• Gearing = Debt Capital ÷ Total Capital
• Leverage = Equity Capital ÷ Total Capital
• Leverage = Total Capital ÷ Debt Capital
Finance - Asset Financing Debt finance used by companies and individuals (e.g., mortgage loan) to increase their return on investment by utilizing the borrowed funds so that the return generated is greater than the cost of servicing the debt (e.g. debt-to-assets ratio).
Banking Financial institutions lend a proportion of deposits to customers that need a loan to make a profit.
Economics Comparison of consumer debt to disposable income used for economic analysis purposes.
Physics Lever effect where a simple machine amplifies a relatively small input force into a greater output force.
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Emilie N., FCCA, CB, MBS
Emilie N., FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from large corporates and banks, as well as fast-growing start-ups.

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