Gearing Ratio

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Description of Gearing Ratio. Explanation.

 

Definition Gearing Ratio. Description.


The Gearing Ratio measures the percentage of capital employed that is financed by debt and long term finance. The higher the gearing, the higher the dependence on borrowings and long term financing. The lower the gearing ratio, the higher the dependence on equity financing. Traditionally, the higher the level of gearing, the higher the level of financial risk due to the increased volatility of profits. Utilizing gearing amplifies the potential gain from an investment or project, but also increases the potential loss.


The Gearing Ratio is calculated as follows: divide Long Term Liabilities by (Equity + Long Term Liabilities) X 100 which results in a percentage.


Note that in the USA the term "Leverage" or "Financial Leverage" is more commonly used.


In certain Financial Debt Covenants, the borrower may be obliged to maintain a certain gearing ratio.


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Compare also: Debt to Equity Ratio  |  Recapitalization  |  Undercapitalization

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