Gearing Ratio

Introduction to Gearing Ratio

  • The gearing ratio is a financial metric that compares some form of owner’s equity, or capital, to borrowed funds.
  • The ratio indicates the degree to which a company’s operations are funded by debt versus shareholders’ equity.
  • It illustrates the financial risk for a business due to the amount of debt it holds.

Formula for Gearing Ratio

  • The gearing ratio can be calculated by dividing Long-Term Liabilities by Shareholders’ Funds, the resultant number is then multiplied by 100 to get the percentage.
  • Alternatively, it may be calculated by dividing Long-Term Liabilities by Capital Employed (Capital Employed = Shareholders’ Funds + Non-Current Liabilities).

Interpretation of Gearing Ratio

  • A high gearing ratio can indicate higher risk, since it means the business has borrowed heavily to finance its operations.
  • Conversely, a low gearing ratio indicates lower risk, as the business is primarily financed by shareholders’ equity, which does not require interest payments.
  • The idea of “high” or “low” is relative, and it depends on the industry norms and the business model of the company. Some businesses may operate efficiently with high gearing.

Limitations of Gearing Ratio

  • Gearing ratios cannot provide a full picture of a company’s financial risk. Other factors such as cash flow stability, profitability, and industry economic conditions should also be considered.
  • Companies with high gearing ratio are more susceptible to fluctuations in interest rates, as increased interest expenses can hurt profitability.
  • The calculation of the gearing ratio depends on the classification of debt and equity, which can vary between companies.

Significance of Gearing Ratio

  • Gearing ratio is a useful tool for investors and financiers to understand the financial structure and the risk level of a business.
  • For managers, understanding the gearing ratio helps in strategic decision making like funding options for corporate expansions.
  • Though an important metric, it should be analysed in conjunction with other aspects in company’s financial statements for a more holistic financial evaluation.