Net debt to equity, debt to capital and tangible gearing, worked on two borrowers, and why the balance sheet ratio and the leverage multiple can rank the same credits in opposite order.
The gearing ratio is net debt divided by shareholders' equity, or in the capitalisation form net debt divided by net debt plus equity. Two illustrative borrowers with the same 120.0 of net debt show 126.3 per cent and 40.0 per cent gearing, yet the low-geared one carries 6.67x EBITDA against 4.22x for the other. Gearing measures debt against accounting equity; a lender is repaid from cash, which is why credit analysis puts the leverage multiple first and reads gearing as a check on the balance sheet.
Worked in full in Credit Analysis by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Gearing is still everywhere: in annual reports, bank credit memos, UK listing documents and some loan covenants, often as a maximum of net debt to tangible net worth. It is worth calculating properly, and worth knowing exactly what moves it.
| Item | A: sponsor-backed packaging group | B: long-established engineering company |
|---|---|---|
| Gross debt | 135.0 | 150.0 |
| Cash | 15.0 | 30.0 |
| Net debt | 120.0 | 120.0 |
| Shareholders' equity | 95.0 | 300.0 |
| Goodwill and intangible assets (on the asset side) | 140.0 | 0.0 |
| EBITDA | 28.46 | 18.0 |
| Net interest | 8.88 | 8.88 |
Gearing (debt to equity) = net debt / equity
Gearing (debt to capital) = net debt / (net debt + equity)
A: 120.0 / 95.0 = 126.3%; 120.0 / 215.0 = 55.8%
B: 120.0 / 300.0 = 40.0%; 120.0 / 420.0 = 28.6%
In Excel: =(Debt-Cash)/Equity and =(Debt-Cash)/(Debt-Cash+Equity). The two forms carry the same information: debt to capital equals g / (1 + g), where g is debt to equity.
State which form you use. "Gearing of 55.8 per cent" and "gearing of 126.3 per cent" describe the same company, and readers in different markets assume different definitions. Gross gearing, before netting cash, is a third variant: 142.1 per cent for A and 50.0 per cent for B.
Tangible gearing. Lenders who use gearing usually strip out goodwill and intangibles, because they cannot be sold to repay debt. A's tangible equity is 95.0 less 140.0, minus 45.0: the ratio is not meaningful and the company has negative tangible net worth. B's tangible gearing stays at 40.0 per cent.
| Measure | A | B | Looks safer |
|---|---|---|---|
| Net debt / equity | 126.3% | 40.0% | B |
| Net debt / (net debt + equity) | 55.8% | 28.6% | B |
| Tangible gearing | n/m | 40.0% | B |
| Net debt / EBITDA | 4.22x | 6.67x | A |
| EBITDA / net interest | 3.20x | 2.03x | A |
B looks conservatively financed on every balance sheet measure and is the weaker credit on every cash flow measure. Its equity is mostly historic retained earnings sitting in old plant; its earnings are 18.0 on 300.0 of equity. Held to A's leverage of 4.2164x, B could carry 75.9 of net debt: it has 44.1 more than its earnings support. A looks over-geared because a buyout put 140.0 of goodwill on its balance sheet and financed it with debt, which is what every leveraged buyout does, and says nothing about whether the cash pays the interest.
| Event | Equity after | Net debt / equity | Debt to capital | Net debt / EBITDA |
|---|---|---|---|---|
| A: goodwill impairment of 40.0 | 55.0 | 218.2% | 68.6% | 4.22x |
| B: property revaluation of 60.0 | 360.0 | 33.3% | 25.0% | 6.67x |
An impairment takes A's gearing from 126.3 to 218.2 per cent without a euro leaving the business; a revaluation takes B's from 40.0 to 33.3 per cent without a euro arriving. A gearing covenant can be breached by an auditor's impairment test. A leverage covenant cannot, which is one reason leveraged loans test leverage and cover rather than gearing.
Suppose both borrowers had a single covenant: net debt no more than 100 per cent of equity. A, at 126.3 per cent, is in breach on the day it signs, although its cash covers interest 3.20 times. B could borrow up to 300.0 of net debt, 180.0 more than today, which on its 18.0 of EBITDA would be 16.67x leverage. A covenant written on book equity polices the wrong borrower here. That is why, where gearing still appears in loan documents, it usually sits beside a leverage or cover test, and why the analyst should compute both before agreeing to either.
Gearing = net debt / equity, or net debt / (net debt + equity): 126.3 and 55.8 per cent for A, 40.0 and 28.6 per cent for B. Calculate it, state the form, and then calculate leverage on the lender's EBITDA, because that is what decides repayment. Which debt and cash belong in the numerator is worked in how to calculate net debt to EBITDA, and how much debt a given EBITDA supports in how to calculate debt capacity from EBITDA. The four EBITDAs of borrower A, and the leverage each gives, are rebuilt in the free workbooks for this book.
It depends on the business model and on how the equity was created. An asset-heavy company with old retained earnings can show 40.0 per cent gearing at 6.67x net debt to EBITDA, while an acquisitive group shows 126.3 per cent at 4.22x. Judge gearing beside leverage and interest cover, never alone.
Gearing compares debt with accounting equity; leverage, in credit analysis, compares debt with earnings, usually net debt to EBITDA. On 120.0 of net debt and 95.0 of equity, gearing is 126.3 per cent; on EBITDA of 28.46, leverage is 4.22x. Leverage measures the ability to repay, gearing the cushion in book value.
Divide net debt by equity less goodwill and intangible assets. For a borrower with 95.0 of equity and 140.0 of intangibles, tangible equity is minus 45.0, so the ratio is not meaningful and the borrower has negative tangible net worth, which is how it should be reported.
This article is one calculation from Credit Analysis. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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