Gearing ratio: what is it and how do you calculate it?

How much a company relies on borrowing is a crucial factor in comparing it to its competitors and, ultimately, deciding whether or not to invest in it.

Having very little borrowing might sound intuitively like a good thing, but in some cases it could be argued a company was not taking advantage of its ability to borrow to drive future growth.

What is the gearing ratio?

The gearing ratio is a measure of a company’s borrowing versus its “net assets”, indicating how much it uses debt or borrowing to keep running and, therefore, how financially secure it may be.

It can be calculated relatively simply and is best used when comparing companies from the same industry where the business models are the same or similar. That’s because different types of companies can be expected to rely on debt to different extents.

Those working in industries with high fixed costs may need to rely on borrowing more versus those in capital-light industries, for instance.

Once calculated, a gearing ratio can be expressed as a percentage. Anything above 50pc might be regarded as high, although this could be justified if the business model requires it.

A reading below 25pc indicates a high level of security, although it may also indicate that a company is not effectively using borrowing to expand its trading.

Gearing ratios give investors an indication of how a company might be affected by changes in interest rates, with highly-geared companies negatively affected by rises on borrowing costs but helped by any falls in rates.

How do you calculate the gearing ratio?

There are different variations of gearing ratios but the most commonly used is “debt-to-equity”, sometimes called “net gearing”.

This is a simple comparison between a company’s total borrowing – including any short- and long-term debt, bank credit facilities, leases and loans and its total equity – which is the value of all of its assets minus all of its liabilities.

Details of these are available in a company’s report and accounts. Figures for “total debt” and “total equity” are published and can usually be found quickly by searching online.

Once found it is simply a case of dividing the total debt by the total equity to give a figure for the gearing ratio. Multiply this by 100 to express as a percentage.

If you really don’t want to do any calculations yourself, debt-to-equity figures are often published online via company factsheets provided by investing platforms.

Worked Example

Gearing ratios are of most use when comparing companies competing in the same industry.

Take BP and Shell, the two oil majors that sit in the FTSE 100 index of the biggest London-listed companies.

Based on its financial results for 2023, BP was operating with total debt of around £63.1bn and total equity of £70.3bn, resulting in a debt-to-equity gearing ratio of almost 89pc.

That compares to Shell, where total debt is £83.8bn and total equity is £190.5bn – a ratio of almost 44pc.

On the basis of that, BP is the more highly geared of the two companies, despite having lower levels of net debt on its balance sheet.

Ed Monk is an investment writer at Fidelity International