Gearing ratio is a type of financial ratio that is used to compare owner’s equity or the capital of a firm with its borrowed funds. The ratio is a tool to measure the financial leverage of the company in order to analyze the percentage by which a firm’s activities are funded by the owner as compared to the activities funded by the creditors. Another name of the gearing ratio is the net gearing ratio. In other words gearing ratio is used to measure the percentage of the capital employed by the firm that is financed by the creditors in the form of debt and long term financing. Higher figure of the gearing ratio indicates that a firm is dependent on creditors for financing in the form of debt where as the lower figure of the gearing ratio indicates that the firm highly depends on the equity financing. Firms having high degree of gearing ratio are considered to be more risky as the volatility of their profits is also high.
High degree of gearing ratio can be prove as a dilemma for the financial managers as they require long term financing and debt for the expansion and growth of their business. In most of the cases only equity financing is not sufficient for achieving long terms goals and expansion of the business. However, debt and long term financing increase the gearing ratio and the firm considered to be risky in financial terms. In reality the high gearing ratio is considered to be the positive aspect of the business as debt gives more return on the employed capital where as firms that are solely dependent on equity financing have low chances of sustaining growth.
For a new and establishing business gearing ratio may be higher as the establishing businesses mostly depend on debt and long term financing for their expansion. However, the gearing ratio must not be higher than 50 percent as it will create a negative image of the business in the market. Gearing ratio is a tool that focuses on the capital structure of the firm. It calculates the portion of the finance provider by the debt or creditors and the portion of the finance provided by the owner’s equity. The major concern of the gearing ratio is with the liquidity of a business however it also analysis the long term financial stability of a business. Gearing proves to b the strong part of the capital structure of a business if a business expects strong and powerful cash inflows.