A gearing ratio is a financial ratio that compares some measure of owner's equity to borrowed funds. Gearing, as a financial term, is a comparison of how much of a firm's activities are funded by borrowed funds as compared to owner's funds. As such, the gearing ratio is a measure of the firm's financial leverage or risk. It is also an indirect measure of the company's business risk.
What is Financial Leverage or Financial Risk
Financial risk is the additional risk a business faces when it finances a portion of its assets with debt financing. Businesses have the option of buying their assets by going into debt or by using the money from people who have invested in the business. In the smallest of businesses, such as tiny home businesses, the only money invested in the business may be the money invested by the owner.
In other small businesses, debt financing may be used exclusively since the business may not have any investors. When debt financing is used, the financial risk of the company increases. Companies cannot use 100% debt financing as that would constitute bankruptcy.
The Gearing Ratio, Interest Payments, Other Fixed Payments
The gearing ratio measures the proportion of firm debt to equity. It also measures the volatility of the business firm and its activities. Financial gearing measures the risk that the company cannot meet the interest payments on its debt and its other fixed costs, such as lease payments. If a company has to struggle to have enough cash on hand to pay its interest payments on debt and other fixed costs like lease payments, then it either has too much debt or too little cash flow. Firms can measure if they have too much debt by looking at industry average financial ratios.
If you, as business owner or financial manager, think of the gearing ratio in this way, here are calculations you can use:
If you have only interest payments, calculate the times interest earned ratio:
Times Interest Earned = Earnings Before Interest and Taxes/Interest = # of Times
where the times interest earned ratio tells you how many times over the business can pay its interest payments on debt. The higher the TIE ratio, the more liquid the firm and the less debt the firm has.
If you have interest payments to make plus other fixed charges such as lease payments, then you should calculate the fixed charge coverage ratio:
Fixed Charge Coverage = Earnings Before Interest and Taxes + Other Fixed Charges/Interest + Other Fixed Charges = # of Times
where the fixed charge coverage ratio tells you how many times over the business can pay its interest payments on debt, lease payments, and other fixed charges. The higher the fixed charge coverage ratio, the more liquid the firm and the less debt and fixed charges the firm has.
The Gearing Ratio - Debt and Equity
When you think of the gearing ratio as the proportion of debt to equity, you have to choose the measures of debt and equity you want to compare. One common ratio to use is the debt to equity ratio. This is a comprehensive measure of gearing as it uses total debt and total shareholder's equity in the ratio:
Debt to Equity = Total Debt/Total Shareholder's Equity = _____%
As the debt to equity ratio increases, gearing also increases along with the financial risk of the firm.
Another ratio you can use to measure gearing is the long-term debt to total capitalization ratio:
Long-term Debt to Total Capitalization = Long-term Debt/Long-term Debt + Shareholder's Equity = ______ %
This ratio shows how much long-term debt, such as mortgages and bonds, finance the firm's total assets. If this ratio is high as compared to industry averages, the firm's gearing is high which is also a measure of financial risk.