## What is Gearing Ratio?

Gearing Ratio is commonly used by financial analysts to understand the overall capital structure of the company by dividing total debt to total equity. The higher the ratio, the higher the chances of default and hence more hindrance in the growth of the company. Similarly, the lower the ratio, the better it is. In addition, there are other formulas where the owner’s capital or equity is compared against the long term or short term debt.

### Gearing Ratio Formula

#1 - Gearing Ratio = Total Debt / Total Equity#2 - Gearing Ratio = EBIT / Total Interest#3 - Gearing Ratio = Total Debt / Total Assets

Where,

EBIT is Earnings Before Interest and Tax.

- The only common thing between all of the formula is that they all include some part of the equity in the calculation, whether it being shareholders fund or reserves or even operating income, which ultimately goes into Shareholder’s equity calculation only.
- This calculation helps in determining how leveraged is the firm is and how stable is the firm in repaying their debts and also continue with their expansion plans without affecting its profitability as well.

The last thought would be the company needs to maintain an adequate debt ratio which fits it’s best.

### Calculation Examples of Gearing Ratio Formula

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

#### Example #1

Huston Inc reports the following numbers to the Bank; you are required to calculate the gearing ratio using Debt to equity ratio.

- Equity Share Capital: 30000000
- Bonds Issued: 25000000
- Chase Mortgage Loan: 35000000
- Current Liabilities: 2500000
- Reserves: 2570000

**Solution:**

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

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Calculation of Gearing Ratio can be done 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. The Bank has put up a condition that its gearing ratio should be more than 4. Otherwise, ABC will be forced to either provide a guarantor or mortgage any property.

You are required to assess on the basis of the following details whether ABC meets the Bank’s expectation of gearing ratio?

- Revenue from Operations: 1050000
- Other Income: 200000
**Total Revenue: 1250000**- Cost of Goods Sold: 682500
- Depreciation: 200000
- Operating Expenses: 105000
- 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, and since this is less than 4 and not meeting the expected ratio of the bank, it will now have to provide a guarantor or mortgage of the property as stipulated.

**Note:**For calculating operating income, other income is usually avoided, but since we don’t have any other detail as to where it is earned from, we presume it to be part of operating income.

#### Example #3

Mr. Raj has a major shareholder of the company XYZ, wants to conduct a financial health check up on the company as, during their last annual general meeting, the board took approval from shareholders to raise 300,000 more debt from external as unsecured.Mr.

Raj wants to make sure 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 total Debt 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 0.65; hence the concern of MR Raj is correct as the firm could end up with the proposed loan for more than 50% of the total assets.

### Relevance and Uses

Financial institutions and creditors primarily use gearing ratios as they are concerned with the repayment capacity of the firm, and accordingly, they can draft the terms and conditions of the proposed loan. These ratios are also used by internal management 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.

### Recommended Articles

This has been a guide to Gearing Ratio and its definition. Here we discuss the formula to calculate the gearing ratio along with examples and a downloadable excel template. You can learn more about financial analysis from the following articles –