Gearing is a popular word in the financial world. It is a synonym of ‘financial leverage’ and both of these words can be used interchangeably. This is a ratio between the amount of own and the amount of borrowed capital in a business, personal budget, or any other financial unit. To learn more about leverage in finance, you can read our example on this matter here.
Gearing Ratio
As we said earlier, the gearing ratio is the percentage of own funds from borrowed funds. An example of this is the debt-to-equity ratio from corporate finance. Let’s say that a company has $12 000 of equity and has borrowed $20 000 in debt. Such a company would have $32 000 of total assets ($12000 + $20000). We can find its debt-to-equity ratio this way:
Equity / Total Debt = 12 000 / 20 000 = 3/5 .
In this example, we can say that this business has a leverage or gearing ratio of 3/5.
More Gearing Ratios
Except for this one, there are some more gearing ratios. Some of them are:
Current Assets / Current Liabilities = Current Ratio
Total Debt / Total Assets
…. more about leverage ratios you can read here:
Gearing Essentials
Gearing is a financial concept that relates to the degree of debt a company has relative to its equity. In simple terms, it refers to the amount of money a company relies on borrowed funds to finance its activities.
Gearing can be expressed as a percentage of total liabilities to total assets. A company with a high gearing ratio will have more debt on its books than it does equity. On the other hand, a low-geared company will have more equity than debt.
Gearing can be understood as an indicator of how leveraged a company is. A high gearing ratio suggests that a company is more leveraged, and carries a greater risk of defaulting on its debt. Likewise, a low ratio signals that the company is less leveraged, and is better able to pay off its debt.
For investors, gearing can provide valuable insights into the financial health of a business. Companies with higher levels of debt are generally considered riskier investments than companies with a low level of debt, as the debt holder is more likely to be first in line to receive any return on their investment should the company become insolvent.
Gearing can also be used as a measure of the efficiency of a company’s financial strategy. Companies that are highly geared may be deemed to have taken on more risk than necessary and be less efficient in their use of capital.
When analyzing a company, it is important to consider both the level of gearing and the type of debt that the company is carrying. Secured debt, such as mortgages or bank loans, is generally seen as less risky than unsecured debt, such as credit card debt or company bonds.
Overall, gearing is an important financial metric and provides investors with useful insights into the risks and efficiency of a company’s financial strategy. By understanding a company’s gearing ratio, investors can make informed decisions regarding their investments.
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