Learn: Gearing Ratio - Calculation and Interpretation

Welcome!Building on what you've already learned about financial ratios, let's explore the gearing ratio. This is an important tool for understanding a business's financial structure and risk levels.

What is Gearing Ratio?The gearing ratio measures the proportion of a business's capital that comes from debt compared to equity (owner's funds). It helps assess financial risk, as higher gearing means greater reliance on borrowed funds.

Why is Gearing Ratio Important?The gearing ratio is important because it shows how dependent a business is on external loans. Businesses with high gearing may face higher risks during economic downturns as they must meet loan repayments. Conversely, low gearing indicates reliance on internal funds, which is generally less risky.

How is Gearing Ratio Calculated?The formula for calculating gearing ratio is:Gearing Ratio (%) = (Non-Current Liabilities / Capital Employed) × 100Where non-current liabilities refer to long-term debts, and capital employed includes all equity and debts used for financing.

Interpreting Gearing RatioA high gearing ratio (e.g., above 50%) means heavy reliance on debt, which could be risky during periods of low revenue. A low gearing ratio (e.g., below 25%) suggests a safer financial position with more reliance on equity.

High vs Low GearingHigh gearing can indicate growth potential but is riskier due to repayment obligations. Low gearing suggests financial stability but might limit growth opportunities if external funding isn't used.

Review Time!Great work! You've learned how to calculate and interpret the gearing ratio. Let's test your understanding with a few questions.