Definition and Explanation
The gearing ratio is the group of financial ratios that compares the owner’s equity in the company, debt, or the number of funds the company borrows. Gearing can be defined as a metric that measures the company’s financial leverage. The key four ratios include Time Interest Earned, Equity Ratio, Debt Ratio, and Debt-toEquity Ratio.
Financial leverage shows the degree to 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 compare shareholders’ equity to the existing company’s amount of debt that the company has drawn.
This is considered to be a critical metric to gauge the company’s leverage, as well as financial stability.
They are compared with the other gearing ratios in the company to get an idea of the existing industry average.
Gearing Ratios are metrics, and to calculate gearing ratios, different aspects of the company are included.
The gearing ratios are different ratios measuring different things about a particular organization. Therefore, they are categorized into the following types:
Times Interest Earned = (Earnings before Interest and Tax) / Total Interest
(Times Interest Earned Ratio represents the company’s total earnings 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 it had to bear. )
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 company’s number of assets and the percentage of those assets backed by the company’s equity.)
Debt Ratio = Total Debt / Total Assets
(Similar to the 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 is attributable to the debt that the company has drawn over the recent years)
Is Gearing Ratio similar to the Debt-Equity Ratio?
The Debt-to-Equity Ratio describes the total debt that the company draws 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 the company draws 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 it tells about how much the company relies on debt versus the equity they have raised over time.
Therefore, it gives a beneficial insight into the company’s leverage position.
Hence, it would not be considered incorrect to say that the debt-to-equity ratio is considered a gearing ratio category.
However, gearing can also be measured using several other metrics and ratios, like the ones mentioned above.
How can Gearing Ratio be improved?
The Gearing Ratio is considered one of the company’s critical metrics. There is no specific ‘ideal’ gearing ratio for the company. It depends from company to company.
The optimal debt-to-equity structure is a factor of many things, including the firm’s weighted average cost of capital, the cost of equity, and the 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.
If the company is lowly geared, it has a significant amount of resources obtained from equity finances. To increase the company’s gearing, they are supposed to get debt.
They can either buy back shares from the existing shareholders (and issue debt against this repurchase) or take on more debt if they want to finance a particular project.
Similarly, if the company is highly geared and wants to reduce the gearing, the company can issue more shares and pay back the debt.
In most cases, servicing the debt and paying back the liabilities automatically reduces the company’s liability.