What is gearing?
Gearing measures the extent to which a company uses borrowed money to finance its activities. It is calculated by dividing the total debt by shareholders' equity and expressing it as a percentage. High gearing ratios indicate higher financial risk and leverage, while lower ratios suggest a more conservative financial position. Gearing helps investors and analysts assess the financial structure and risk profile of a company.
How is gearing calculated?
Gearing is typically calculated using the following formula:
Gearing = (Total Debt / Shareholders' Equity) × 100
Total debt refers to the outstanding borrowings of a company, while shareholders' equity represents the value of the shareholders' ownership in the company. By expressing gearing as a percentage, we can understand the level of debt relative to the equity invested in the business.
Real world example of gearing
Let's imagine a fashion company called Fashionista Boutique. The company has shareholders' equity (total value of investments made by shareholders) of $1 million. Fashionista Boutique has also borrowed $500,000 from a bank to expand its operations and invest in new product lines.
To calculate the gearing ratio, we divide the total debt ($500,000) by the shareholders' equity ($1,000,000) and multiply by 100:
Gearing = ($500,000 / $1,000,000) × 100 = 50%
This means that Fashionista Boutique has a gearing ratio of 50%. It indicates that 50% of the company's capital structure is financed through debt, while the remaining 50% comes from the shareholders' investments.
Understanding gearing
Gearing is an important measure because it reflects the financial risk and how much leveraging a company is using, In other words, how much they're borrowing. A high gearing ratio suggests that a significant portion of a company's structure is financed through debt. While debt can provide financial flexibility and growth opportunities, it also increases the risk as the company must meet make sure it can keep up with an repayments on debts. On the other hand, a low gearing ratio indicates a more conservative financial position, where a smaller proportion of the company's capital is funded by debt.