Gearing Ratio - Home Loan Equity Loan
By Colin Nicholson
In June and July 2008, I discussed the debt to equity ratio. This is one of the more common financial risk ratios used by investors. As a reminder, the debt to equity ratio is simply the net financial debt of a company divided by the shareholders funds. It is usually expressed as a percentage. The higher this ratio, the more financial risk there is in the way a company has been financed.
Almost as common is the gearing ratio. It is somewhat different to the debt to equity ratio. It is also quite common for investors to confuse the two ratios they may know which ratio they mean, but they use the wrong name. This can easily lead to misunderstandings if the listener is thinking of the correct ratio for that name. This highlights the need to ensure that we know the definition of terms used in any written or spoken discussion of debt levels. If in doubt, ask or find out the definition used.
The gearing ratio is simply the net financial debt divided by the sum of shareholders funds plus net financial debt.
Net financial debt is the total interest paying debt of a company less the cash on hand.
To calculate this ratio, then, we need three totals:
- Financial debt any debt on the balance sheet, current or non-current and including finance leases.
- Cash the amount of cash on the balance sheet under current assets.
- Shareholders funds from the balance sheet.
Let's assume those numbers are:
Financial Debt $850m
Shareholders funds $1,960m
The calculation would be:
Gearing = (850 25) (1960 + 850 25) x 100 = 29.6%
It should be noted that the gearing ratio will always be a lower percentage than the debt to equity ratio. In this example, the debt to equity ratio would be:
Debt to Equity = (850 25) 1960 x 100 = 42.1%
This highlights the importance of understanding the definition of the ratio being used in any discussion.
Colin Nicholson's books: Building Wealth in the Stock Market and The Psychology of Investing may be purchased from Colin's website www.bwts.com.au and good bookstores). Contact Colin at firstname.lastname@example.org or through his web site where you may join the list to receive his free email newsletter.