What is a Gearing Ratio?
A gearing ratio measures the amount of financial leverage a business has. There are a number of gearing ratios including the debt equity ratio and the debt ratio. In this tutorial the debt ratio is used to indicate the level of gearing or financial leverage and is defined as the ratio of how much a business owes (debt) compared to the total of the debt plus the amount the owners have invested (equity).
The gearing ratio is calculated by dividing debt by debt plus equity.
What is the formula for the Gearing Ratio?
- Debt is given in the balance sheet and includes loans, overdrafts, hire purchase and any other borrowings. The bank may include leasing when calculating the gearing ratio as they take a stricter approach.
- Owners Equity is found in the balance sheet and includes amounts invested by the owners and any retained earnings.
How is the Gearing Ratio Calculated in Practice?
| Cash | 30,000 |
| Accounts receivable | 100,000 |
| Inventory | 20,000 |
| Current assets | 150,000 |
| Long term assets | 390,000 |
| Total assets | 540,000 |
| Accounts payable | 90,000 |
| Other liabilities | 40,000 |
| Current liabilities | 130,000 |
| Long-term debt | 210,000 |
| Total liabilities | 340,000 |
| Capital | 50,000 |
| Retained earnings | 150,000 |
| Total equity | 200,000 |
| Total liabilities and equity | 540,000 |
In the above example the total debt is 210,000 and the owners equity is 200,000. The financial gearing is calculated as follows:
Gearing ratio = Debt / (Debt + Equity) Gearing ratio = 210,000 / (210,000 + 200,000) = 51.22%
Consider now what happens when the debt forms a higher proportion of the businesses finance.
| Cash | 30,000 |
| Accounts receivable | 100,000 |
| Inventory | 20,000 |
| Current assets | 150,000 |
| Long term assets | 220,000 |
| Total assets | 370,000 |
| Accounts payable | 90,000 |
| Other liabilities | 40,000 |
| Current liabilities | 130,000 |
| Long-term debt | 180,000 |
| Total liabilities | 310,000 |
| Capital | 10,000 |
| Retained earnings | 50,000 |
| Total equity | 60,000 |
| Total liabilities and equity | 370,000 |
In the above example the total debt is 180,000 and the owners equity is 60,000. The financial gearing is given as follows:
Gearing ratio = Debt / (Debt + Equity) Gearing ratio = 180,000 / (180,000 + 60,000) = 75%
In this case the owners equity is reduced, possibly by losses and the gearing has increased to 75%.
What does the Gearing Ratio show?
A bank would not normally want to lend more than the owners of a business so from their point of view the maximum gearing ratio is 50%. Example 1 above shows approximately a 50% gearing situation. In Example 2 above, the balance sheet gives an unacceptable gearing ratio of 75%. The business is said to be highly geared or under capitalized, and a bank would view the business as having too much debt to allow it to borrow further funds.
Useful tips for using the Gearing ratio
- A bank will be reasonable happy with a gearing ratio of 50% but will normally look for a gearing ratio of 25% – 50%
- A higher gearing ratio means higher risk.
- Typically the gearing ratio will be 50%, but it varies from industry to industry.
- Financing a business through debt is not a bad thing as it reduces the amount that owners have to invest in the business and will give greater returns to the owners provided cash and profit are managed correctly.
- However, a highly geared business which has a gearing ratio greater than 50%, is more risky as the debt and interest payments need to be made before the owners get their return.
Debt Ratio and Debt Equity Ratio
The debt equity ratio is the ratio of the debt to the equity of the business and is another example often used as a gearing ratio. The two terms are linked by the following formulas.
DER = Debt equity ratio = Debt / Equity
DR = Gearing or debt ratio = Debt / Assets = Debt / (Debt + Equity)
and
DER = Debt equity ratio = Debt / Equity
DR = Gearing or debt ratio = Debt / Assets = Debt / (Debt + Equity)
So for example, if the debt ratio is given as 60%, then the debt equity ratio is calculated as follows:
DER = DR / (1 - DR) DER = 60% / (1 - 60%) DER = 1.50