Gearing Ratio

Gearing Ratio

Gearing focuses on the capital structure of the business. The gearing ratio is the proportion of a company's debt to its equity. A high gearing ratio represents a high proportion of debt to equity, and a low gearing ratio represents a low proportion of debt to equity. Gearing also known as "leverage" measures the proportion of assets invested in a business that are financed by long-term borrowing.

A high gearing ratio is indicative of a great deal of leverage, where a company is using debt to pay for its continuing operations. The higher the level of borrowing (gearing) the higher are the risks to a business. However, gearing can be a financially sound part of a business's capital structure particularly if the business has strong, predictable cash flows.

A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are. A high gearing ratio is less of a concern where a business is in a monopoly situation and its regulators are likely to approve rate increases that will guarantee its continued survival.

A low gearing ratio is indicative of conservative financial management. It may also mean that a company is located in a highly cyclical industry, and so cannot afford to become overextended in the face of a downturn in sales and profits.

The formula for calculating gearing is:

Long-term debt + Short-term debt + Bank overdrafts
Shareholders' equity