Meaning and definition of gearing ratio
Quite closely related to solvency ratio, gearing ratio is a general term recounting a financial ratio comparing some form of owner’s capital (equity) to borrowed funds. Moreover, gearing is a quantification of financial leverage, indicative of the extent to which a firm’s activities are financed by owner’s finances vs. creditor’s finances. Putting another way, gearing ratio is used mainly for analyzing a company’s capital structure and thus assessing the company’s financial position in the long run.
As stated by Investopedia the higher degree of a company’s leverage indicates the company to be more risky. However, this level of gearing can be changed or managed through certain financial activities. For most of the ratios, an up to standard level is determined by weighing it against ratios of companies in the same industry.
Examples of Gearing Ratio
Some of the most common examples of gearing ratio include the time interest earned ratio (EBIT / total interest), the debt-to-equity ratio (total debt / total equity), debt ratio (total debts / total assets), and the equity ratio (equity / assets), capitalization ratio.
Significance of Gearing Ratio
The gearing ratio is significant to a company and the potential investors. it is essential to circumspectly plan as it affects the company’s ability to maintain a consistent dividend policy during intricate operating periods. Moreover, the gearing ratio reveals the suitability of capitalization of a company.