Gearing ratio can be defined as the ratio a company’s debt to that of its equity. This is also called as debt to equity ratio. High gearing ratio means that ratio of debt to equity is high and vice versa. Sometimes this ratio is also compared to debt to equity ratio as it has a number of similarities to that ratio however there are a few variances that can yield a slightly different results from debt to equity ratio.
The high gearing ratio depicts that the company is standing at a high leverage point where it is using debt to carry on its business operations or to pay off its liabilities. High leverage shows that a company is in difficult situation regarding reimbursement of its debt and it may face bankruptcy due to high leverage and lack of capital funding. The situation becomes even worse if a company is experiencing multiple interest rates over the acquired debt.
In order to calculate gearing ratio all the long term and short term debts a business has acquired in that accounting period are added along with the bank overdrafts acquired by the business. The sum of all the debts and bank overdrafts is then divided by the shareholder equity of the business. The formula of gearing ratio can be depicted as follows:-
Gearing Ratio = Long Term Debt + Short Term Debt + Bank overdrafts/ Shareholder Equity
Gearing ratio can also be calculated on the biases of total earnings before taxes and interests. Here the total earnings before taxes and interests is divided by interest payable for that earnings. The formula can be shown as under:-
Gearing Ratio = Times Interest Earned Ratio = EBIT / Interest Payable
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