Gearing ratio is a general term that refers to several formulas and ratios that measure the amount of wealth that a business possesses as opposed to the money it owes to creditors. On a large scale, the ultimate gearing ratio is calculated by taking all of a company's borrowed money and dividing it into the amount of equity it holds, borrowings included. More specific ratios that fall under this blanket term include interest coverage ratio, debt/equity ratio, equity ratio, and debt ratio. All of these calculations are meant to judge a company's leverage, which is a measure of how much of its funding comes from outside sources as opposed to from the owners of the business.
Many companies and businesses amass debt at some time during its existence, as borrowing money is often a necessary step to long-term financial growth. If those borrowed amounts start to eat up too much of the percentage of a company's capital, then the company is said to be heavily leveraged and vulnerable. Even if the business takes a downturn, the debt still has to be paid off, and a highly-leveraged business may struggle to make those payments.
Using gearing ratio to measure the amount of leverage is a solid way for investors to make decisions on the financial strength of a company. By comparing the different leverage ratios other companies in the same industry, a clear picture of that company's reliance on debt is achieved. Generally speaking, the more volatile the business, the less a business should be leveraged. That's because businesses in such industries need to be able to weather highs and lows more readily.
For the most complete picture of a company's independence from debt, an overall gearing ratio, in which the amount of capital a company has is divided by its total money owed, may be useful. From that general overview, specific ratios can be used to pinpoint the individual areas where a company is either weak or strong in terms of how it is leveraged. The debt/equity ratio is similar to the overall gearing ratio, with a slight reversal in that it takes the debt and divides it by the equity.
Similar to these is debt ratio, which is total debt divided by total assets, and equity ratio, which is equity divided by assets. In addition there is the interest coverage ratio, also known as times interest earned, which pays special attention to the interest owed on borrowed money. This number is reached by first totaling the earnings of a company before interest and taxes, and then dividing it by the amount of interest owed.
