What is Gearing Ratio?

Financial analysts commonly use the gearing ratio to understand the company’s overall capital structure by dividing total debt into total equity. The higher ratio, the higher the chances of default. Thus, hindering growth is more of a hindrance to the company’s development. In addition, there are other formulas where the owner’s capital or equity compare against the long-term or short-term debt.

Gearing Ratio Formula

#1 - Gearing Ratio = Total Debt / Total Equity

#2 - Gearing Ratio = EBIT / Total Interest

#3 - Gearing Ratio = Total Debt / Total Assets

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Where,

EBIT is Earnings Before Interest and TaxEarnings Before Interest And TaxEarnings before interest and tax (EBIT) refers to the company’s operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization’s profit from business operations while excluding all taxes and costs of capital.read more.

  • The only common thing between all the formulas is that they all include some part of the equity in the calculation, whether it is shareholders’ funds, reserves, or even operating income, which ultimately goes into shareholder’s equity calculation.This calculation helps determine how leveraged the firm is and how stable it is in repaying its debts and continuing its expansion plans without affecting its profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more.

The last thought would be the company needs to maintain an adequate debt ratio that fits its best.

Calculation Examples of Gearing Ratio Formula

Let us see some simple to advanced practical examples to understand it better.

Example #1

Huston Inc. reports the following numbers to the bank. First, calculate the gearing ratio using the Debt-to-equity ratioDebt To Equity RatioThe debt to equity ratio is a representation of the company’s capital structure that determines the proportion of external liabilities to the shareholders’ equity. It helps the investors determine the organization’s leverage position and risk level. read more.

  • Equity share capital: $30,000,000Bonds issued: $25,000,000Chase mortgage loan: $35,000,000Current liabilities: $2,500,000Reserves: $2,570,000

Solution:

We will first calculate the company’s total debt and equity and then use the above equation.

One can do the calculation of the gearing ratio as follows: –

So this will be: –

Example #2

ABC has been recently hit by the competition and is looking for a loan from the bank. However, the bank has decided that its gearing ratio should be more than 4. Otherwise, ABC will be forced to either provide a guarantor or mortgage any property.

Based on the following details, you need to assess whether ABC meets the bank’s expectation of gearing ratio.

  • Revenue from operations: $1,050,000Other income: $200,000Total revenue: $1,250,000Cost of goods sold: $682,500Depreciation: $200,000Operating expenses: $105,000Interest expenses: $70,000Tax expenses: $57,750Total expenses: $1,115,250Net profit: $134,750

We will first calculate the total interest and EBIT of the company and then use the above equation.

Calculation of gearing ratio can be done as follows: –

Hence, the ratio will be 3.75. Since this is less than 4 and does not meet the bank’s expected ratio, it will now have to provide a guarantor or mortgage of the property as stipulated.

Note: For calculating operating income, other income is avoided, but since we do not have any additional details about where it earns, we presume it to be part of operating income.

Example #3

Mr. Raj is a major shareholder of XYZ Co. and wants to conduct a financial health check-up. During their last annual general meeting, the board took approval from shareholders to raise $300,000 more debt external as unsecured. Mr. Raj wants to ensure that the total debt should not be more than 50% of the total assets. You are required to calculate the gearing ratio based on the below information: –

We will first calculate the company’s total debt and then use the above equation.

Therefore, the ratio will be 0.65. Hence, Mr. Raj’s concern is correct, as the firm could end up with the proposed loan for more than 50% of the total assets.

Relevance and Uses

Financial institutions and creditors primarily use gearing ratios as they are concerned with the repayment capacity of the firm. Accordingly, they can draft the terms and conditions of the proposed loan. Internal management also uses these ratios to analyze their future profit and cash flows. Usually, where high investment is involved, gearing ratios tend to be higher as they have to afford those. Financial institutions and creditors primarily use gearing ratios as they are concerned with the repayment capacity of the firm. Accordingly, they can draft the terms and conditions of the proposed loan. Internal management also uses these ratios to analyze their future profit and cash flows. Usually, where high investment is involved, gearing ratios tend to be higher as they have to afford those CapExCapExCapex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more via externally secured fundings.

This article is a guide to Gearing Ratio Formula. Here, we discuss the calculation of gearing ratio, examples, and a downloadable Excel template. You can learn more about financial analysis from the following articles: –

  • Revenue Per EmployeeRevenue Per EmployeeRevenue Per Employee is the ratio of total revenue over total number of employees in a particular accounting period. It gives an idea about how the business performed.read moreCapEx examples CAPEX ExamplesCapital Expenditure or Capex refers to the total expenditure on the purchase of assets by the company in a given period and the example of which includes spending on purchase of buildings, office types of equipment, intangible assets, furniture and fixtures, computer equipment, and motor vehicles, expenditure on the extension or the addition of the assets, etc.read more.Capital Gearing Ratio CalculationCapital Gearing Ratio CalculationCapital Gearing, also called Financial Leverage, is the level of debt that a Company utilizes for obtaining assets. It is determined as the ratio of Total Equity to Total Debt. read moreFormula of Leverage RatiosFormula of Debt to Asset Ratio