Financial analysts commonly use the gearing ratio to understand the company’s overall capital structure by dividing total debt into total equity. The higher ratio, the higher the chances of default. Thus, hindering growth is more of a hindrance to the company’s development. In addition, there are other formulas where the owner’s capital or equity compare against the long-term or short-term debt.

• The gearing ratio, or leverage ratio, is a financial metric that measures the proportion of a company's debt to its equity. 
• Moreover, other formulas allow the owner's capital or equity to compare against long-term or short-term debt.
• Financial institutions and creditors primarily prefer to utilize the gearing ratios as they are concerned with the firm's repayment capacity. Accordingly, they prepare the proposed loan terms and conditions of the proposed loan. 
• In addition, internal management uses ratios to determine future profit and cash flows.

Let us see some simple to advanced practical examples to understand it better.

Example #1

Huston Inc. reports the following numbers to the bank. First, calculate the gearing ratio using the Debt-to-equity ratio.

• Equity share capital: $30,000,000
• Bonds issued: $25,000,000
• Chase mortgage loan: $35,000,000
• Current liabilities: $2,500,000
• Reserves: $2,570,000

Solution:

We will first calculate the company's total debt and equity and then use the above equation.

One can do the calculation of the gearing ratio as follows: –

So this will be: -

Example #2

ABC has been recently hit by the competition and is looking for a loan from the bank. However, the bank has decided that its gearing ratio should be more than 4. Otherwise, ABC will be forced to either provide a guarantor or mortgage any property.

Based on the following details, you need to assess whether ABC meets the bank's expectation of gearing ratio.

• Revenue from operations: $1,050,000
• Other income: $200,000
• Total revenue: $1,250,000
• Cost of goods sold: $682,500
• Depreciation: $200,000
• Operating expenses: $105,000
• Interest expenses: $70,000
• Tax expenses: $57,750
• Total expenses: $1,115,250
• Net profit: $134,750

Solution:

We will first calculate the total interest and EBIT of the company and then use the above equation.

Calculation of gearing ratio can be done as follows: -

So this will be: -

Hence, the ratio will be 3.75. Since this is less than 4 and does not meet the bank's expected ratio, it will now have to provide a guarantor or mortgage of the property as stipulated.

Note: For calculating operating income, other income is avoided, but since we do not have any additional details about where it earns, we presume it to be part of operating income.

Example #3

Mr. Raj is a major shareholder of XYZ Co. and wants to conduct a financial health check-up. During their last annual general meeting, the board took approval from shareholders to raise $300,000 more debt external as unsecured. Mr. Raj wants to ensure that the total debt should not be more than 50% of the total assets. You are required to calculate the gearing ratio based on the below information: –

Solution:

We will first calculate the company's total debt and then use the above equation.

Calculation of gearing ratio can be done as follows: -

So this will be: -

Therefore, the ratio will be 0.65. Hence, Mr. Raj's concern is correct, as the firm could end up with the proposed loan for more than 50% of the total assets.

Financial institutions and creditors primarily use gearing ratios as they are concerned with the repayment capacity of the firm. Accordingly, they can draft the terms and conditions of the proposed loan. Internal management also uses these ratios to analyze their future profit and cash flows. Usually, where high investment is involved, gearing ratios tend to be higher as they have to afford those. Financial institutions and creditors primarily use gearing ratios as they are concerned with the repayment capacity of the firm. Accordingly, they can draft the terms and conditions of the proposed loan. Internal management also uses these ratios to analyze their future profit and cash flows. Usually, where high investment is involved, gearing ratios tend to be higher as they have to afford those CapEx via externally secured fundings.

This article is a guide to Gearing Ratio Formula. Here, we discuss the calculation of gearing ratio, examples, and a downloadable Excel template. You can learn more about financial analysis from the following articles: -

• Revenue Per Employee
• CapEx examples.
• Capital Gearing Ratio Calculation
• Formula of Leverage Ratios
• Formula of Debt to Asset Ratio