It is a comparison between an individual company and other companies in the same industry that determines a good or bad gearing ratio. To identify desirable and undesirable ratios, there are some basic guidelines to follow:

Anything above 50% is considered a high gearing ratio
Anything below 25% is considered a low gearing ratio
Gearing ratios between 25% and 50% are optimal
A company with a high gearing ratio will typically use loans to cover operational costs, exposing it to increased risk during economic downturns or interest rate increases. This could result in financial difficulties, if not bankruptcy.

A company with a low gearing ratio will typically have more conservative spending habits or will operate in a cyclical industry - one that is more sensitive to economic ups and downs - in order to keep its debts low. Companies with low gearing ratios maintain this by paying for major costs with shareholder equity.

A gearing ratio helps investors understand the relationship between a company’s debt and its equity financing. A lower ratio is often associated with lower financial risk because the company has fewer debt-related obligations. A higher ratio can indicate increased leverage, meaning the company may be more vulnerable to rising interest rates, declining revenues, or economic downturns. Nevertheless, a high gearing ratio is not necessarily bad, just as a low ratio is not automatically good. Some businesses can successfully use significant debt to finance expansion and generate higher returns. The key is whether the company has sufficient earnings and cash flow to service its borrowing. To assess gearing properly, investors should compare a company with businesses in the same sector and examine changes in its ratio over time. It is also useful to review interest coverage, cash flow, profitability, and liquidity. Ultimately, a good gearing ratio remains appropriate for the company’s industry, financial capacity, and long-term strategy.