Gearing Ratio

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, is 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

The following formula is used to calculate the Gearing Ratio for a firm:

Gearing  =  Long Term Loans  x  100%

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Capital Employed

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 Mean?

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. This is because firms have to pay interest on their loans before they can pay dividends to shareholders and high gearing leaves less money for business investments.

What Does A Low Gearing Ratio Mean?

Analysts say that firms with a low gearing ratio are a low risk investment because they impact of interest rate changes on them is smaller than the impact for highly geared firms. For low geared firms the pressure of loan repayments will be smaller (than highly geared firms) during periods of poor trading.

However low gearing may mean that the firm has less money available for business investments and therefore, it may not be able to benefit from opportunities for growth.

Conclusion

As always when analysing the financial health and long term potential of a firm you should analyse a range of information. Looking at Financial Ratios alone will not provide a complete picture; review ratios and financial statements such as Balance Sheets, Cashflow and Profit and Loss Account.