Gearing Ratio: What Is It and How to Calculate It?

What is the Gearing Ratio?

The gearing ratio, also known as the net debt ratio or debt-to-equity ratio, provides a quick understanding of a company's financial situation.

Its calculation formula includes elements from the company's liabilities. Beyond the purely financial aspect, the gearing ratio provides insight into the weight of certain stakeholders in the business.

It's an indicator that allows you to draw several conclusions, as we'll see! But above all, it shows whether your company's financial structure is sound or not! So why not use it?

Calculation Elements and Gearing Formula

To calculate the net debt ratio, you need to understand two concepts that we'll break down together below.

Net Debt:

• Total financial debts (most often bank loans)
• + Shareholder current accounts (amounts owed by the company to shareholders)
• - Available cash (cash and securities the company holds)

This result gives the residual debt at time T, if the company had to repay everything with its current cash.

Shareholders' Equity:

This is composed of:

• Share capital: The contributions made by shareholders when the company was created
• Legal reserve: A mandatory reserve required by law
• Other reserves and retained earnings: Amounts that could have been paid as dividends but were kept in the company

This represents what the company would have to pay shareholders if it were dissolved and liquidated.

The Gearing Ratio Formula:

Gearing Ratio = (Net Debt / Shareholders' Equity) × 100

How to Interpret the Gearing Ratio?

If all goes well, your calculator will display a percentage! The net debt ratio represents the weight of debt compared to shareholders' equity.

• 0 to 25%: The company has low debt. It has good room for maneuver to seek loans and external financing. Shareholders' equity primarily finances the company. In this situation, the main fund providers are the shareholders.
• 25% to 70%: This is the situation for most companies. Those who have just taken out a loan are closer to the high end. Conversely, those who have almost finished repaying their loans are closer to 25%.
• Over 70%: Without being alarmist, it's essential to reduce exposure. The company is financed mainly by external fund providers (banks, investors, etc.). The company therefore has a strong dependency on these third parties.

Refine Your Gearing Reading with Context!

Sometimes, there's an opportunity to borrow even if the company doesn't necessarily need to!

For example, if interest rates are low, or in the case of government-guaranteed loans.

This would mechanically increase the ratio, without necessarily indicating a shaky financial structure!

Additionally, a low net debt ratio can indicate missed development opportunities. That's right!

If you can borrow at low rates to develop before you need the liquidity, it's a useful strategic choice for the long term!

Debt VS Shareholders' Equity

We can take the reasoning a bit further! Come on, courage, we're almost done! And you'll learn even more!

The issue around debt isn't just about financial structure – that wouldn't be interesting!

One characteristic of debt is that it generates interest!

This interest is deducted from the company's results just like all other expenses, which leads to tax savings.

Some companies therefore choose to take on debt rather than reinject funds through shareholders, because the impact of interest on results is more advantageous.

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