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GEARING RATIO

Introduction

This ratio measures the size of the firm’s long term loans against the size of the amount of money invested in the company. This ratio is expressed as a percentage. If a business has a high gearing ratio it means that a large amount of the money invested in the business has come from long term loans. Conversely a low gearing ratio means that a small proportion of the money invested in the business comes from long term loans.

How Do You Calculate A Firm's Gearing Ratio?

Gearing =        long-term loans       x 100%
                        Capital employed

Gearing Ratio Diagram

What Are Long Term Loans?

  • Long term loans are made up of bank loans and debentures.
  • A debenture is usually a bond that is bought from the firm. The firm will pay interest to the holders of the debenture. 
  • Capital employed is made up of loans, share capital and reserves.

What Does A High Gearing Ratio Meaning?

A firm with a gearing ratio of more than 50% is said to be highly geared. If a company has a high gearing ratio it means that it has lots of long term borrowing. Anybody putting money into a business (with a high gearing ratio) will need to closely look at the firm’s ability to cover long term loans especially if the economy is not doing well for example in a recession. People looking to invest in a highly geared business will also need to look at the level of dividends and the firm’s share prices to decide whether they will make any money from investing in the business.


 

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