Gearing Ratio Definition Explanation & Formula
Definition
The gearing ratio represents a group of financial ratios that compare some form of owner’s equity (or capital) to debt, or funds borrowed by the company. Gearing is a measurement of the entity’s financial leverage, which demonstrates the degree to which a firm’s activities are funded by shareholders’ funds versus creditor’s funds.
Explanation
The gearing ratio, with reference to a financial market, is a popular financial ratio that compares a company’s debt to other financial metrics such as business equity or company assets. It represents a measure of financial leverage that finds to what degree a company’s actions are funded by shareholder equity in comparison with creditors’ funds.
The gearing ratio formula help provides clarity into the sourcing of a firm’s operating funds, which provides greater insight into a company’s reliability and whether they are able to withstand periods of financial instability.
It is a measure of financial leverage that demonstrates the degree to which a firm’s operations are funded by equity capital versus debt financing (when a company raises money by selling debt instruments to investors).
Gearing Ratio Formula
When it is calculated by dividing total debt by total assets, it is also called the debt-equity ratio. Following is the most commonly used formula for calculating the gearing ratio:
Where D stands for total debt i.e. the sum of interest-bearing long-term and short-term debt such as bonds, bank loans, etc. It also includes other interest-bearing liabilities such as pension obligations, lease liabilities, etc. E is the shareholders’ equity which includes common stock, additional paid-up capital, retained earnings, irredeemable preferred stock, etc.
In addition to the capital structure ratios above, a company’s gearing is also analyzed using the interest cover ratio, degree of the operating leverage ratio, degree of the financial leverage ratio, degree of the total leverage ratio, and Break–even point.
