Gearing Ratio I
Gearing Ratio = Debt x 100
Equity
Variations to the basic quantification,
Gearing Ratio II
Gearing Ratio = Debt x 100
Debt + Equity
Expresses debt as a function of total funding profile
What is Gearing?
Gearing is a tool that is used by investors and businesses to show how much of the long term finance came from loans and how much came from shareholder funds. It also shows how exposed the firm is to financial risk.
Gearing Ratio
The Gearing Ratio looks at the level of borrowing that a company has taken on in the form of loans and compares that to the total long term finance that a business has.
As a ratio, obtain a percentage figure from the formula. Since the formula shows the ratio of Loans to (shareholder funds + Loans), the percentage obtained tells us a few things.
High Gearing – where a high % of the long term finance is in the form of loans. A high percentage is a figure that is over 50%.
Low Gearing – where a low % of the long term finance is in the form of loans. A low percentage is a figure that is between 0% and 50%
What Does the Gearing Figure mean for the Business and Shareholders?
Gearing shows a firms exposure to financial risk. A high gearing percentage tells us that the firm has a high level of loans compared to shareholder funds. The high level of loans also means that the firm has to pay a higher interest charge. This means that if profits were low, or did not meet predicted levels then the firm would have a tough time paying off the interest charges, which would affect other areas of the firm e.g. a lower investment into Research & Development for a year. So the greater the gearing percentage the greater the exposure to risk and the risk of interest rate rises.
For shareholders and potential investors the gearing level is important, and as such it is a very important tool when analyzing whether a business is a viable investment:
Potential investors view firms that are highly geared as being a risky investment
Higher gearing raises the exposure to interest rate changes, so investors will be put off investing if they feel that interest rates will rise
Higher gearing means that the company will be in risk of liquidation if it cannot meet interest payments
Investors looking to give a loan to the company will also look at the gearing ratio
A highly geared company will already be paying high interest charges, so investors will be put off from give it a further loan as the firm may not be able to pay it back
A low geared firm is more likely to get a loan from investors since its loan payments are low, and its exposure to risk is also low.
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