Gearing is basically defined as the ratio between a company's borrowing (debt) and owner's equity (i.e. shareholder's fund). It is synonym to the word leverage.

A number of ratios fall under the bracket of Gearing Ratio. Thus Debt Equity Ratio and Interest Cover or Times Interest Earned are the more common examples of Gearing Ratio, which are mostly used.

Formula, examples and interpretation of the more common types of Gearing Ratio are explained below.

Gearing Ratio

Formula

Gearing Ratio = Total Borrowings / (Total Borrowings + Total Equity) * 100

Example

A Company has Equity contributed by Shareholder's amounting to $ 100,000. The funds borrowed from the Bank amount to $ 50,000 for the purpose of purchase of Plant & Machinery.

Gearing Ratio = 50,000 / (50,000 + 100,000) * 100

Gearing Ratio = 33%

Interpretation

In this case 33% of the total funds are contributed by way of borrowings. Thus the proportion of debt to total funds appears to be reasonable. However this ratio needs to be compared with other companies in the industry to judge the reasonableness.

In a capital intensive industry Gearing Ratio of 50% or less can be considered reasonable. Capital Gearing Ratio above 50% is considered to be risky, since borrowing funds has a cost attached to it by way of interest. Once funds are borrowed, the principal and interest are required to be paid irrespective of the performance of the business. Thus a high Capital Gearing Ratio leads to high risk.

Debt Equity Ratio

Formula

Debt Equity Ratio = (Total Debt / Total Equity) * 100

Example

A Company has Equity amounting to $ 50,000 and has borrowed funds by way of Long Term Loan amounting to $ 75,000 for funding the construction of building and purchase of Plant & Machinery. A Short Term Loan of $ 25,000 is taken for funding the Working Capital Requirement.

Debt Equity Ratio = (100,000 / 50,000) * 100

Debt Equity Ratio = 200%

Interpretation

A Debt Equity Ratio of 200% is considered to be very high. There is heavy dependence on borrowed funds which means more risk. In this case the company will need to perform and have sufficient Operating Profits from the first year itself in order to meet the interest cost and repay the first year loan installment. In case the company has struck a deal to start repayment of the loan after a couple of years it would have that time period available for setting up and growth of the business. Within this time period the company would be required to make sufficient Cash Profits in order to repay the loan.

In case the Debt Equity Ratio is 200% after the company has commenced business and operated for a period of few years, then it would be interpreted to be very unhealthy and high risk, unless a major expansion is planned.

As stated above, the Debt Equity Ratio would need to be compared with the industry norms to ascertain the reasonableness. A capital intensive industry would be having a high Debt Equity Ratio as compared to trading business.

Gearing Ratio Vs. Debt Equity Ratio

There are debates and arguments as to the correctness of calculation of Gearing Ratio. What is the correct formula for calculating Gearing Ratio? Is the Gearing Ratio the same as Debt Equity Ratio?

It can be observed from the above examples that Gearing Ratio and Debt Equity Ratio give similar results except the result %age will be much higher in the case of Debt Equity Ratio. It finally does not matter which method of calculation is being used. It is the interpretation of the ratio which is more important and comparison of the results with industry norms.

The key thing to remember is that before increasing your borrowing the risks and returns need to be balanced.

Interest Cover

Interest Cover or Times Interest Earned is another important ratio which falls in the bracket of Gearing Ratio's.

Formula

Interest Cover or Times Interest Earned = Operating Profit (EBIT) / Total Interest

Example

A company has made an operating profit of $ 8,000. The Interest Paid during the year is $ 4,000.

Interest Cover = 8,000 / 4,000

Interest Cover = 2

Interpretation

The Interest Cover ratio is more relevant where the Gearing Ratio is high. Thus in this case if the interest rates go up, the company is in a critical situation since it will eat away the profits.

The interpretation of the Interest Cover ratio given above is also dependent on the performance of the Company. Has the company made sufficient profits at the operational level? The Operating Profit to Sales would need to be calculated and compared with the Projections.

Lower the interest cover higher the risks. If interest cover is 1 or less than the company may suffer liquidity problems and may need to identify alternative sources of finance. Additional capital introduction by the owners may need to be considered.