Definition and Explanation
Gearing Ratio is defined as the financial ratio that draws a comparison between the owner’s equity in the company, to debt, or to the amount of funds that are borrowed by the company. Gearing can be defined as a metric that measures the company’s financial leverage.
Financial leverage basically shows the degree with which the operations, and the overall company if funded with equity financing versus debt financing.
Therefore, to summarize gearing ratios can be defined as a group of financial metrics that are used to compare shareholders’ equity to the existing company’s amount of debt that the company has drawn.
This is considered to be a very important metric to gauge the company’s leverage, as well as financial stability. They are compared with the other gearing ratios that exist in the company in order to get an idea about the existing industry average.
Gearing Ratios are metrics, and in order to calculate gearing ratios, different aspects of the company are included.
The gearing ratios are defined as different ratios that measure different things about the particular organization. Therefore, they are categorized as the following types:
Times Interest Earned = (Earnings before Interest and Tax) / Total Interest
(Times Interest Earned Ratio is a representation of the total earnings of the company, as a percentage of the interest that the company has paid. This helps to show how much the company has earned, against the interest and the financial cost that they had to bear as a result. )
Equity Ratio = Equity / Assets
(Equity Ratio is a representation of the total equity that the company has, as a percentage of the total assets. This shows the amount of assets that the company has, the percentage of those assets, which are backed by equity of the company.)
Debt Ratio = Total Debt / Total Assets
(Similar to equity ratio, the debt ratio is considered to be a representation of the total assets that the company has, and out of those assets, how much are attributable to the debt that the company has drawn over the recent years)
Is Gearing Ratio similar to Debt-Equity Ratio?
The debt-to-Equity Ratio describes the total debt that is drawn by the company against the total equity that the owners of the company have raised. It directly shows the percentage of the company that is leveraged by debt.
In other words, it shows the amount of debt that is drawn by the company against every $1 of equity raised by the company. It is calculated using the following formula:
Debt-to-equity Ratio = Total Debt / Total Equity
Often this particular ratio is referred to as the gearing ratio. It is mainly because of the fact that it tells about the extent to which the company is reliant on debt, versus the equity that they have raised over the period of time. Therefore, it gives a very useful insight about the leverage position of the company.
Hence, it would not be considered incorrect to say that debt-to-equity ratio is considered to be a category of the gearing ratio. However, gearing can also be measured using other several metrics and ratios, like the ones mentioned above.
How can Gearing Ratio be improved?
Gearing Ratio is considered to be one of the very important metrics of the company. There is no specific ‘ideal’ gearing ratio for the company. It depends from company to company.
As a matter of fact, optimal debt-to equity structure is a factor of a multitude of things, including the weighted average cost of capital of the firm, as well as the cost of equity and cost of debt that the company has.
However, there are costs and benefits associated with being highly geared and lowly geared. Depending on the situation that suits the company best, this can be subsequently prescribed.
In the case where the company is lowly geared, it means that the company has significant amount of resources obtained from equity finances. In order to increase the gearing of the company, they are supposed to get debt.
They can either buy back shares from the existing shareholders (and issue debt against this repurchase), or they can simply take on more debt – in the case where they are looking to finance a particular project.
In the same manner, in the case where the company is highly geared, and they want to reduce the gearing, the company has an option to issue more shares, and pay back the debt. In most cases, servicing the debt, and paying back the liabilities automatically reduces the liability of the company.