Gearing is concerned with the capital structure of a business. Specifically, it measures the degree to which a company's debt, or money that needs to be paid back by the business, is balanced with equity which is contributed by the shareholders. The higher the gearing, the higher the risks to the business. That's because more of its revenues are tied up in debt and interest repayments.
The most comprehensive gearing ratio is the debt-to-equity ratio. This takes all forms of debt and divides it by the shareholders' equity.
A gearing ratio is not one metric but many. The best-known examples include the equity ratio (equity/assets), the times interest earned ratio (earnings before interest and taxes/total interest), the debt-to-equity ratio (total debt/total equity) and the debt ratio (total debt/total assets). What these ratios have in common is they all measure, in some form or another, the degree to which a firm's activities are funded by debt versus equity financing.
The most comprehensive ratio is the debt-to-equity gearing formula as this takes all forms of debt – short-term, long-term and overdrafts – and divides it by the shareholders' equity. The formula is:
(Long-term debt + short-term debt + bank overdrafts) / shareholders' equity
As an example, suppose that Adipose Industries, a new company, has $1 million of debt and $600,000 of shareholders' equity. The debt-to-equity gearing ratio is an eye-watering high of 166 percent ($1,000,000/ $600,000). In year five, Adipose decides to hold an initial public offering which raises its equity base to $2 million. This company now has a 50 percent gearing ratio assuming the debt load stays the same.
A company with a high gearing ratio of 50 percent or more is said to be highly leveraged, which means it has a lot of debt to service. This does not mean the business is doing poorly – it just means the company has a riskier capital structure than a business with lower gearing. This company may be vulnerable to rising interest rates and economic downturns since debt and interest payments, unlike shareholder's equity, must always be paid. Every business is different, however. A mature business that generates stable and robust cash flows may be able to handle a much higher level of gearing than an early-stage business where cash flows are unpredictable. Something between 25-and-50 percent would be considered a sensible gearing level for a well-established business that is happy to finance some of its activities with debt.
Lenders are concerned about a high gearing ratio since it puts their loan at risk of default. Banks are likely to look at another gearing ratio, the interest coverage ratio formula (earnings before interest and taxes/ interest expenses) to determine how easily a business can pay the interest charges on outstanding debt. The lower the interest coverage ratio, the more the business is burdened by debt expense and the less likely it is to secure a loan. One obvious way to reduce a company's gearing ratio is to sell shares in the company and use the cash raised to pay down debt. Some lenders will also convert their loans by swapping out some of the debt for shares in the company.