# Gearing Ratio

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

A company must strike a balance between the proportion of debt and equity in its capital structure. Adding debt to capital structure magnifies the return on equity due to existence of interest tax shield i.e. the decrease in income taxes that result from deductibility of interest expense for tax purposes. This is the consequence of Modigliani and Miller propositions. However, increased debt level increases the risk of bankruptcy and exposes the company to financial risk. Companies attempt to identify their optimal capital structure i.e. the gearing ratio that minimizes the weighted average cost of capital.

## 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 gearing ratio:

$$ \text{Gearing Ratio}=\frac{\text{D}}{\text{E}} $$

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

$$ \text{Debt to Capital Ratio}\ =\frac{\text{D}}{\text{D}+\text{E}} $$

Where **D** is the total debt is defined as 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, capital leases (also called finance leases), 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

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

USD in million | 2014 | 2015 | 2016 | 2016 | 2018 |
---|---|---|---|---|---|

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 ratios | Calculation | 2014 | 2015 | 2016 | 2016 | 2018 |
---|---|---|---|---|---|---|

Short-term debt | 11,773 | 6,402 | 5,453 | 3,355 | 8,995 | |

Capital leases - short term | 309 | 287 | 551 | 565 | 667 | |

Long-term debt | 41,771 | 41,086 | 38,214 | 36,015 | 30,045 | |

Capital leases - long-term | 2,788 | 2,606 | 5,816 | 6,003 | 6,780 | |

Total interest-bearing liabilities | D | 56,641 | 50,381 | 50,034 | 45,938 | 46,487 |

Total shareholders' equity | E | 76,255 | 81,394 | 80,546 | 77,798 | 77,869 |

Gearing ratio (most common definition) | D/E | 0.74 | 0.62 | 0.62 | 0.59 | 0.60 |

Gearing ratio (less common definition) | D/(D+E) | 0.43 | 0.38 | 0.38 | 0.37 | 0.37 |

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 2014 to just 60% of the equity in 2018.

by Obaidullah Jan, ACA, CFA and last modified on