Gearing Formula

Gearing Formula (Table of Contents)

• Formula
• Examples

What is the Gearing Formula?

The term “gearing” refers to the group of financial ratios that demonstrate to what degree are the operations of a company funded by debt financing vs equity capital. In other words, the metrics signify the mix of funding from lenders and from the shareholders. There are three major gearing ratios –

1. Debt-to-Equity Ratio
2. Equity Ratio
3. Debt Ratio

The formula for debt-to-equity ratio is expressed as the company’s total debt divided by its total equity. Mathematically, it is represented as,

The formula for equity ratio is expressed as the company’s total equity divided by its total assets. Mathematically, it is represented as,

The formula for debt ratio is expressed as the company’s total debt divided by its total assets. Mathematically, it is represented as,

Examples of Gearing Formula (With Excel Template)

Let’s take an example to understand the calculation of Gearing in a better manner.

Gearing Formula – Example #1

Let us take the example of a company with the following information retrieved from its annual report: Calculate the company’s gearing ratio based on the given information.

Solution:

Debt-to-Equity Ratio is calculated using the formula given below

Debt-to-Equity Ratio = Total Debt / Total Equity

• Debt-to-Equity Ratio = $35 million / $25 million
• Debt-to-Equity Ratio = 1.40x

Equity Ratio is calculated using the formula given below

Equity Ratio = Total Equity / Total Assets

• Equity Ratio = $25 million / $75 million
• Equity Ratio = 0.33x

Debt Ratio is calculated using the formula given below

Debt Ratio = Total Debt / Total Assets

• Debt Ratio = $35 million / $75 million
• Debt Ratio = 0.47x

Therefore, the company’s debt-to-equity ratio, equity ratio and the debt ratio are 1.40x, 0.33x and 0.47x respectively.

Gearing Formula – Example #2

Let us take an example of more detailed financial information to illustrate the computation of gearing ratios. Use the following information to compute the gearing ratios:

Solution:

Total Debt is calculated using the formula given below

Total Debt = Long Term Debt + Short Term Debt

• Total Debt = $50,000 + $20,000
• Total Debt = $70,000

Debt-to-Equity Ratio is calculated using the formula given below

Debt-to-Equity Ratio = Total Debt / Total Equity

• Debt-to-Equity Ratio = $70,000 / $150,000
• Debt-to-Equity Ratio = 0.47x

Equity Ratio is calculated using the formula given below

Equity Ratio = Total Equity / Total Assets

• Equity Ratio = $150,000 / $230,000
• Equity Ratio = 0.65x

Debt Ratio is calculated using the formula given below

Debt Ratio = Total Debt / Total Assets

• Debt Ratio = $70,000 / $230,000
• Debt Ratio = 0.30x

Therefore, the company’s debt-to-equity ratio, equity ratio and the debt ratio are 0.47x, 0.65x and 0.30x respectively.

Gearing Formula – Example #3

Let us take the example of Apple Inc. and calculate the gearing ratios according to the annual report’s financial report for the year 2018. The following is available:

Solution:

Total Debt is calculated using the formula given below

Total Debt = Commercial Paper + Term Debt

• Total Debt = $11,964 million + $102,519 million
• Total Debt = $114,483 million

Debt-to-Equity Ratio is calculated using the formula given below

Debt-to-Equity Ratio = Total Debt / Total Equity

• Debt-to-Equity Ratio = $114,483 million / $107,147 million
• Debt-to-Equity Ratio = 1.07x

Equity Ratio is calculated using the formula given below

Equity Ratio = Total Equity / Total Assets

• Equity Ratio = $107,147 million / $365,725 million
• Equity Ratio = 0.29x

Debt Ratio is calculated using the formula given below

Debt Ratio = Total Debt / Total Assets

• Debt Ratio = $114,483 million / $365,725 million
• Debt Ratio = 0.31x

Therefore, Apple Inc.’s debt-to-equity ratio, equity ratio and debt ratio for the year 2018 were 1.07x, 0.29x and 0.31x, respectively.

Screenshot of balance sheet used for calculation

Source Link: Apple Inc. Balance Sheet

Explanation

The formula for different gearing ratios can be derived by using the following steps:

Step 1: Firstly, determine the total debt of the company, which is the aggregate of all long-term and short-term interest-bearing liabilities such as term loan, working capital loan, capital lease, etc.

Step 2: Next, determine the company’s total equity, which is also known as shareholder’s equity.

Step 3: Next, determine the company’s total assets, which is the sum of all capitalized resources employed in the business.

Step 4: The formula for a debt-to-equity ratio can be derived by dividing total debt (step 1) by total equity (step 2), as shown below.

Debt-to-Equity Ratio = Total Debt / Total Equity

The formula for equity ratio can be derived by dividing total equity (step 2) by total assets (step 3), as shown below.

Equity Ratio = Total Equity / Total Assets

The formula for debt ratio can be derived by dividing total debt (step 1) by total assets (step 3). Mathematically, it is represented as,

Debt Ratio = Total Debt / Total Assets

Relevance and Use of Gearing Formula

It is important to understand the concept of gearing ratios because most lenders and analysts use these financial ratios to assess an entity’s degree of leverage. Typically, a higher value of equity ratio and lower value of debt-to-equity ratio and debt ratio indicates sound financial health. However, please note that the gearing ratios should be compared among companies operating in the same industry as these ratios are very industry-specific.