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.
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|
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.
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|
|Liabilities and stockholders' equity|
|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|
|Deferred taxes liabilities||8,017||8,805||7,321||9,344||8,354|
|Other long-term liabilities||1,491|
|Total non-current liabilities||59,151||57,040||54,416||54,099||48,132|
|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||20X4||20X5||20X6||20X7||20X8|
|Capital leases - short term||309||287||551||565||667|
|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 20X4 to just 60% of the equity in 20X8.
by Obaidullah Jan, ACA, CFA and last modified on