A gearing ratio measures how much a company relies on borrowed money compared with the money provided by its shareholders. It is one of the simplest ways to judge how financially stretched a business is. A highly geared company has a lot of debt relative to its equity, while a lowly geared company relies more on its own funds. With rising borrowing costs and stories about heavily indebted utilities in the news, gearing is a useful idea to understand.
How it is calculated
There are a few versions of gearing, but the most common in the UK compares net debt with shareholders’ equity:
- Net debt is total borrowing minus cash.
- Shareholders’ equity is the value of the company’s assets minus its liabilities, as shown on the balance sheet.
- Gearing is net debt divided by equity, usually shown as a percentage.
As a purely illustrative example, a company with £400 million of net debt and £800 million of equity would have gearing of 50 per cent. If net debt rose to £800 million with equity unchanged, gearing would be 100 per cent.
Some analysts use a debt-to-equity ratio based on total debt, while others compare debt with total capital, which is debt plus equity. The labels vary, so it is worth checking which version you are looking at.
What high and low gearing mean
High gearing means a company has borrowed heavily relative to the size of its equity. That can boost returns for shareholders in good times, because the business has more money working for it. But it also means larger interest payments and less room for error if profits fall.
Low gearing suggests a more cautious balance sheet. The company may be more resilient in a downturn, though some investors argue it could be missing chances to grow.
There is no single “right” level. What matters is whether the company’s earnings and cash flow can comfortably support its debt.
Why some industries run higher gearing
Businesses with steady, predictable income often carry more debt. Regulated utilities, such as water and energy networks, are classic examples. Their revenues are relatively stable, and they need large sums to build and maintain infrastructure, so borrowing is a normal part of how they operate.
Even so, high gearing can become a problem if costs rise, regulators limit price increases or lenders lose confidence. Our earlier guide today on special administration for UK water companies shows what can happen when a heavily indebted utility runs into serious trouble.
Why interest rates matter
When interest rates rise, companies with lots of debt usually face higher costs as loans and bonds are refinanced. That can squeeze profits and make investors more nervous about highly geared names. Some UK utilities have debt linked to inflation, which means repayments can also grow when prices rise.
This is why gearing is often discussed alongside measures of how easily a company can cover its interest payments from its earnings.
How gearing fits with other measures
Gearing works best alongside other tools. Enterprise value, covered earlier today, adds debt to market value to show the cost of buying the whole business. Return on equity can look flattering in a highly geared company, because a small equity base makes returns look bigger, so it helps to check both together.
Common mistakes to avoid
- Comparing gearing across very different industries without adjusting for how they operate.
- Looking only at debt and ignoring cash flow and interest costs.
- Assuming low gearing always means a safer company, regardless of its other risks.
Bringing it together
A gearing ratio compares a company’s debt with its shareholders’ equity. It shows how much a business depends on borrowing, which affects both potential returns and risk. Higher gearing is normal in some sectors, but it leaves less margin for error when rates rise or profits fall.
If you would like to test how well you read company balance sheets, our free trader assessment is a sensible next step.
