The Gearing Ratio in Bookkeeping

The Gearing Ratio in Bookkeeping- Complete Controller.

The gearing ratio measures the proportion of funds borrowed by a company to equity. It is calculated as the total loan (liabilities of the long and short-term included in this loan) divided by the total equity of the shareholder. This is an important term used in bookkeeping. A specific formula is used to calculate the gearing ratio in bookkeeping.

It is the amount of equity needed to pay outstanding debtsLow gearing is the best option for SMEs because a company with a 10% gearing ratio could pay off debts more quickly, and investors consider it a low-risk company. Also, companies with a high gearing ratio of around 50% or above are considered a greater risk because they could be defaulters or bankrupt if profits decline for small periods or rates of interest increase.

The gearing ratio is one of the most common tools to evaluate the financial fitness of a company. The formula to calculate the gearing ratio in bookkeeping is as follows.

Gearing Ratio Formula = Debt / (Debt + Equity)

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Types of Gearing

Financial gearing

Financial gearing includes using debt to fund a business.

The risk is increased by financial gearing, though returns are raised. The debt is a risk for the business. It is a relationship between loan and equity, i.e., how a business is funded.

Operational gearing

This term is used less commonly. It is the relationship between fixed costs and variable costs of the business.ADP. Payroll – HR – Benefits

Disadvantages of Higher Gearing Ratio

A higher gearing ratio suggests abundant leverage when an SME is consuming debt to pay for its ongoing operations. In a trade recession, such SMEs may face distress while meeting schedules of their debt and are at risk of bankruptcy. The condition is hazardous when a firm is involved in debt engagement interest rates, which are variable because a sudden rise in rates could lead to serious problems in the payment schedule.

A regulated industry such as utilities is not as affected by this. They have a monopoly in business, and regulatory authorities will increase the rate to cover the gap and ensure their continued survival. Possible requirements by financiers to lessen this problematic situation are restricting agreements that disallow the payment of shares, enforcing extra cash flow into debt repayment, constraining substitute usages of cash, and imposing conditions for shareholders to place additional equity into the firm. Creditors have a similar concern but are commonly incapable of enforcing alterations on the firm’s conduct.

SMEs that require large fixed assets have higher gearing ratios. A company with a low gearing ratio may manage finances conservatively. However, it may indicate that a company is sited in highly cyclical diligence and can’t afford to turn overextended in the aspect of an unavoidable downturn in trades and revenues.Download A Free Financial Toolkit

Methods to Reduce Gearing Ratio

In bookkeeping, the value of the gearing ratio of a company can be reduced by the following methods:

Trade shares

If an SME is able to get permission from its board of directors to sell shares, then the revenue received after selling shares could be utilized to pay loans. 

Convert debt

These debts could be converted into shares after negotiating with lenders. 

Decrease working capital 

There are two ways to decrease the working capital: reducing inventory levels and escalating the speed at which receivable accounts are collected. The second is to increase the duration in which accounts payable are required to pay and lengthen the days needed. These methods produce cash, which is used to pay off debts. 

Escalation of profits

Practice all known methods to increase revenues so that more cash is generated, which could be used to pay off loans.


SMEs should maintain a low gearing ratio as it shows that the company is financially stable. This will result in attracting a large number of potential investors or lenders.

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