Gearing Ratio

Gearing ratio measures a company’s financial leverage, the level of interest-bearing liabilities in its capital structure. It is most commonly calculated by dividing total debt by shareholders equity. Alternatively, it is also calculated by dividing total debt by total capital (i.e. the sum of equity and debt capital).

As interest expense is tax deductible in most jurisdictions, a company can magnify its return on equity by increasing the proportion of debt in its capital structure. This is a consequence of Modigliani and Miller propositions. However, increased debt level increases the risk of bankruptcy and exposes the company to financial risk. Hence, companies attempt to identify their optimal capital structure, the proportion of debt and equity at which its weighted average cost of capital is minimum. It is because this is the point at which its value would be maximum. The gearing ratio tells a company its current proportion of debt in its capital structure.

Formula

When gearing ratio is calculated by dividing total debt by total assets, it is also called debt to equity ratio.

Following is the most common formula for calculating the gearing ratio:

 Gearing Ratio = D E

The gearing ratio calculated by dividing total debt by total capital (which equals total debt plus shareholders equity) is also called debt to capital ratio.

 Debt-to-Capital Ratio = D D + E

Where D is the total debt i.e. the sum of interest-bearing long-term and short-term debt such as bonds, bank loans, etc. It also includes other interest-bearing liabilities such as pension obligations, lease liabilities, etc. E stands for shareholders equity which includes common stock, additional paid-up capital, retained earnings, irredeemable preferred stock, etc.

In addition to the capital structure ratios above, a company’s gearing is also analyzed using the interest cover ratio, degree of operating leverage ratio, degree of financial leverage ratio, degree of total leverage ratio and financial break-even point.

Example

Given the following data for five years for Walmart Inc. (NYSE: WMT), use the gearing ratios to analyze the company’s long-term financial viability:

USD in million 20X4 20X5 20X6 20X6 20X8
Total assets 204,751 203,706 199,581 198,825 204,522
Liabilities and stockholders' equity
Current liabilities
Short-term debt 11,773 6,402 5,453 3,355 8,995
Capital leases 309 287 551 565 667
Accounts payable 37,415 38,410 38,487 41,433 46,092
Taxes payable 3,520 3,613 3,065 3,737 3,718
Accrued liabilities 12,762 13,254 13,649 13,916 13,295
Deferred revenues 2,017
Other current liabilities 3,566 3,306 3,414 3,922 3,737
Total current liabilities 69,345 65,272 64,619 66,928 78,521
Non-current liabilities
Long-term debt 41,771 41,086 38,214 36,015 30,045
Capital leases 2,788 2,606 5,816 6,003 6,780
Deferred taxes liabilities 8,017 8,805 7,321 9,344 8,354
Minority interest 5,084 4,543 3,065 2,737 2,953
Other long-term liabilities 1,491
Total non-current liabilities 59,151 57,040 54,416 54,099 48,132
Total liabilities 128,496 122,312 119,035 121,027 126,653
Total stockholders' equity 76,255 81,394 80,546 77,798 77,869

The following table shows the calculation of gearing ratio based on the two most common definitions:

USD in million, except for ratiosCalculation20X420X520X620X720X8
Short-term debt11,7736,4025,4533,3558,995
Capital leases - short term309287551565667
Long-term debt41,77141,08638,21436,01530,045
Capital leases - long-term2,7882,6065,8166,0036,780
Total interest-bearing liabilitiesD56,64150,38150,03445,93846,487
Total shareholders' equityE76,25581,39480,54677,79877,869
Gearing ratio (most common definition)D/E0.740.620.620.590.60
Gearing ratio (less common definition)D/(D+E)0.430.380.380.370.37

As shown by the table above, Walmart has reduced debt in its capital structure over the last five years, from 74% of the equity in 20X4 to just 60% of the equity in 20X8.

by Obaidullah Jan, ACA, CFA and last modified on

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