What is Gearing Ratio?

Full Definition

The gearing ratio (sometimes called financial leverage) measures the proportion of a business's capital that comes from debt compared with shareholder equity, and is a key indicator of financial risk. A highly geared (highly leveraged) business relies heavily on borrowing relative to owner-invested capital, which can amplify returns to shareholders when things go well -- because profits are shared among a smaller equity base -- but also increases the risk of financial distress if revenue falls, since interest and loan repayments must still be paid regardless of how trading is going, unlike dividends to shareholders which can be reduced or skipped. Lenders, credit rating agencies and investors watch gearing closely: a business seeking a new loan or renewing an existing facility will often find lenders apply gearing covenants (maximum allowed gearing levels) as a condition of lending, and breaching such a covenant can trigger a review or even early repayment demand even if the business is otherwise trading well. What counts as an acceptable gearing level varies significantly by industry -- capital-intensive sectors like property and utilities typically operate with much higher gearing than service businesses with few physical assets -- so gearing is usually best interpreted against sector norms and alongside the interest coverage ratio, which shows how comfortably a business can actually afford its debt interest from current profits.

How Gearing Ratio is calculated

Worked example: A company with GBP 200,000 of debt and GBP 300,000 of shareholder equity has a gearing ratio of (200,000 / (200,000 + 300,000)) x 100 = 40%.

See Also