# Gearing Ratio Analysis

## 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.

## Gearing Ratio Formula • 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 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 ratio of 50% but will normally look for a ratio of 25% – 50%
• A higher ratio means higher risk.
• Typically the 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 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.

DR = DER / (1 + DER)
Variables used in the debt ratio formula
DER = Debt equity ratio = Debt / Equity
DR = Gearing or debt ratio = Debt / Assets = Debt / (Debt + Equity)

and

DER = DR / (1 – DR)
Variables used in the debt equity ratio formula
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
```
Last modified January 17th, 2020

## About the Author

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.