Gearing and Leverage

Gearing is a ratio or measurement that compares the equity of a business (or person) against the debt they have. This ratio shows how much of your activities are funded by equity versus debt. It is also a measure of your financial stability.

Leverage on the other hand is a term that refers to the amount of debt that a business (or person) has to fund their investments.

If the amount of debt to equity is high then a business would be considered to be highly geared or leveraged. This does not mean the business is in a poor financial condition but that it has a risker financing structure. The gearing or leverage ratio by itself is only at one point in time, so to get the best use of this ratio you should compare it over time (months and years) and against other comparable businesses. Some industries or sectors can operate at higher gearing levels than others.

There are many different gearing ratios but the most common one used is:

Debt to Equity Ratio = Total Debt divided by Total Equity

What is a good or bad Gearing Ratio?​​

To find out if your business has a good or bad gearing ratio you need to compare it to:-

• What it has been in the past

• Other businesses within the same industry

• Budgets or forecasts prepared by management

For individuals your goal is to reduce your gearing over time, so the best guide is comparing your gearing to previous years.

As a rough guide you can use the following to see if you have a good or bad gearing ratio:-

• Highly geared - anything above 0.5 or 50%

• Low gearing - anything lower than 0.25 or 25%

• Optimal gearing ratio - anything between 0.25 (25%) and 0.5 (50%)

How do you calculate your Gearing Ratio?

You have a house worth $1,000,000 and other assets of $300,000. You owe the bank $450,000 in loans. Your equity is therefore $850,000.

Your gearing is $450,000 divided by $850,000 is 0.53 or 53% - not bad……

What is your Gearing Ratio?

James

Image source: https://www.cielsolutions.com/product/week-13-financial-gearing-leverage/