Business is all about balance, which is why the gearing ratio can prove essential. Explore the meaning of gearing ratio in greater depth with our comprehensive guide.
Gearing ratio meaning
The gearing ratio compares a company’s debt to the owner’s equity or capital. It may also be known simply as “gearing,” and it’s a vital tool for understanding the risk of failure that a business faces. Gearing generally refers to leverage. Therefore, the gearing ratio measures the proportion of assets a company has that are financed by long-term borrowing, compared to those which are funded by shareholders. A highly geared business would have a high proportion of debt to equity. The gearing ratio in accounting is used to determine long-term stability for the finances of the company.
What is a good gearing ratio?
Generally speaking, highly geared companies are more likely to have issues making principle payments should they experience financial difficulties. A highly geared company has a ratio of around 50%, while 25% would be considered a low gearing ratio. That said, it’s important to compare a company’s gearing ratio to other organisations in the same industry. A company with a monopoly over the market may continue to function well even with a high gearing ratio, while businesses that need to be more competitive would struggle.
What is the gearing ratio formula?
The gearing ratio formula helps calculate how “geared” a company is:
Financial Gearing = (Short-Term Debt + Long-Term Debt + Capital Leases) / Equity
There is also the “times earned interest” ratio, which shows if a company’s profits can cover their continued interest payments:
Earnings Before Interest and Taxes / Interest Payable
Gearing ratio example
Imagine that a company has £50,000 of debt and £25,000 in equity, resulting in a gearing ratio of 200%. However, it sells stock to the public, giving it an increased equity of £100,000. The gearing ratio equation would be reduced to 50%, even though its debts haven’t changed.
As you can see, it’s possible to lower a company’s gearing ratio even if the debt owed by that company hasn’t been reduced. Some of the ways this can be achieved include:
Swapping debt for shares in the company
Lengthen payment terms on your accounts payable, freeing up cash to pay off debt.
How important is the gearing ratio in accounting?
The gearing ratio equation is critical for lenders and investors. A high gearing ratio means a company is at greater risk of bankruptcy. It will also have a say on the types of loans the company can get. For example, a loan with a variable interest rate – and therefore, unpredictable monthly payments – could prove challenging. The gearing ratio equation can also be used by your firm’s internal teams to better understand and analyse future cash flows.
How does a high gearing ratio impact lending?
If your company has a high gearing ratio, you may also have to give away more control of your business to secure funds. In the eyes of a lender, the higher the gearing ratio, the higher the chances of not getting repaid, so they’ll stipulate that controls are put in place to ensure funds flow in their direction first. This can include the use of covenants, which can restrict your future activity. In some cases, a covenant will prevent you from paying dividends while money is still owed.
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