What is the gearing ratio?
Business is all about balance, which is why the gearing ratio can prove essential. Explore the meaning of gearing ratio in greater depth with our comprehensive guide. Gearing ratio meaning  The gearing ratio compares a companys debt to the owners equity or capital. It may also be known simply as gearing, and its a vital tool for understanding the risk of failure that a business faces. Gearing generally refers to leverage. Therefore, the gearing ratio measures the proportion of assets a company has that are financed by long-term borrowing, compared to those which are funded by shareholders. A highly geared business would have a high proportion of debt to equity. The gearing ratio in accounting is used to determine long-term stability for the finances of the company. Generally speaking, highly geared companies are more likely to have issues making principle payments should they experience financial difficulties. A highly geared company has a ratio of around 50%, while 25% would be considered a low gearing ratio. That said, its important to compare a companys gearing ratio to other organisations in the same industry. A company with a monopoly over the market may continue to function well even with a high gearing ratio, while businesses that need to be more competitive would struggle. The gearing ratio formula helps calculate how geared a company is:  Financial Gearing = (Short-Term Debt + Long-Term Debt + Capital Leases) / Equity  There is also the times earned interest ratio, which shows if a companys profits can cover their continued interest payments:  Earnings Before Interest and Taxes / Interest Payable  Gearing ratio example  Imagine that a company has $50,000 of debt and $25,000 in equity, resulting in a gearing ratio of 200%. However, it sells stock to the public, giving it an increased equity of $100,000. The gearing ratio equation would be reduced to 50%, even though its debts havent changed. As you can see, its possible to lower a companys gearing ratio even if the debt owed by that company hasnt been reduced. Some of the ways this can be achieved include:  Swapping debt for shares in the company  Lengthen payment terms on your accounts payable, freeing up cash to pay off debt. The gearing ratio equation is critical for lenders and investors. A high gearing ratio means a company is at greater risk of bankruptcy. It will also have a say on the types of loans the company can get. For example, a loan with a variable interest rate  and therefore, unpredictable monthly payments  could prove challenging. The gearing ratio equation can also be used by your firms internal teams to better understand and analyse future cash flows. If your company has a high gearing ratio, you may also have to give away more control of your business to secure funds. In the eyes of a lender, the higher the gearing ratio, the higher the chances of not getting repaid, so theyll stipulate that controls are put in place to ensure funds flow in their direction first. This can include the use of covenants, which can restrict your future activity. In some cases, a covenant will prevent you from paying dividends while money is still owed. We can help  GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.