What Is the Gearing Ratio? #
The gearing ratio tells you how much of a company’s money comes from loans versus how much comes from the owner’s investment. It helps businesses understand how much they depend on borrowed money.
Why Is the Gearing Ratio Important?
If a company has too much debt, it can struggle to pay back loans. If it has too little debt, it might not grow quickly. A good balance helps businesses stay stable, attract investors, and qualify for loans when needed.
Why Small Businesses in India Should Care
Many small businesses in India borrow money to grow. Banks and investors look at the gearing ratio to decide whether to lend money or invest. A strong ratio makes it easier to get funding and run a healthy business.
Key Parts of the Gearing Ratio #
The gearing ratio compares debt and equity (owner’s money in the business).
Formula for Gearing Ratio
Gearing Ratio = Total Debt / Total Equity
- Total Debt: All loans and borrowed money.
- Total Equity: Money invested in the business by the owner.
What the Ratio Tells You
- High Gearing Ratio: The company uses a lot of debt. Riskier, but can lead to faster growth.
- Low Gearing Ratio: The company depends more on owner investment. Safer but may grow slowly.
How the Gearing Ratio Affects Business #
Affects Borrowing Ability
Banks and financial institutions carefully analyze a company’s gearing ratio before approving loans. A high gearing ratio (more debt than equity) makes a business appear risky, as lenders may doubt its ability to repay loans, leading to higher interest rates or loan rejections.
On the other hand, a low gearing ratio suggests financial stability but may indicate that the company isn’t using available funding opportunities efficiently. Striking a balance ensures a business can secure loans at favorable terms when needed.
Influences Investor Confidence
Investors look at the gearing ratio to assess a business’s financial health. A very high gearing ratio may signal excessive reliance on borrowed money, raising concerns about financial instability. This can make it harder to attract investors, as they may fear losses if the business struggles with repayments.
However, a moderate gearing ratio shows that a company is leveraging debt responsibly to grow, making it more appealing to investors who seek a balance between risk and return.
Impacts Profitability
When used wisely, a high gearing ratio can lead to increased profits. Borrowed money can be invested in expansion, new equipment, marketing, or hiring skilled staff, helping the business grow faster. However, if a company takes on too much debt without generating enough revenue, loan repayments and interest costs can eat into profits, potentially leading to financial distress. Businesses must ensure they earn a higher return on investment (ROI) than their borrowing costs to maintain profitability.
Determines Business Stability
A well-managed gearing ratio is essential for business stability, especially during economic downturns. A company with high debt levels may struggle to make repayments if revenue drops, increasing the risk of cash flow problems, financial stress, or even bankruptcy.
Conversely, businesses with a balanced gearing ratio are more resilient and can continue operations smoothly, even in tough times. Regularly monitoring and adjusting the gearing ratio helps businesses prepare for uncertainties and maintain long-term stability.
Steps to Calculate the Gearing Ratio #
- Find Total Debt: Add all the company’s short-term and long-term loans.
- Find Total Equity: Check how much money the business owner has invested.
- Use the Formula:
Gearing Ratio = Total Debt / Total Equity
Example Calculation
A business has:
- ₹50 lakhs in total debt
- ₹100 lakhs in total equity
The gearing ratio is:
0.5 or 50%
This means the business has ₹0.50 of debt for every ₹1 of investment.
How to Manage and Improve the Gearing Ratio #
Keep a Balance: A company should not rely too much on loans. It’s important to use a mix of equity and debt for funding.
Regularly Check the Ratio: Businesses should review their gearing ratio every few months to ensure they are not taking on too much debt.
Reduce High-Interest Debt
- Paying off expensive loans first.
- Negotiating better interest rates with banks.
Use Profits Wisely: Instead of taking more loans, businesses can use a portion of their profits to fund growth.
Consider Alternate Funding
- Government grants or subsidies for small businesses.
- Investors or partners who can invest money without adding debt.
Real-Life Business Examples #
Retail Store in Mumbai
A small shop had a high gearing ratio because of multiple loans. By reducing its debts and reinvesting profits, it improved its financial stability.
Manufacturing Startup
A new factory needed funding to expand. It kept its gearing ratio moderate by using both loans and investor money, avoiding too much reliance on debt.
Best Practices for Small Businesses #
- Keep Debt Under Control – Avoid taking unnecessary loans.
- Monitor Financial Health – Regular checks keep the gearing ratio stable.
- Be Transparent with Investors and Lenders – Trust builds financial credibility.
- Prepare for the Unexpected – Savings reduce loan dependency.
- Compare with Industry Standards – Staying competitive ensures financial success.
FAQ’s: #
What is considered a good gearing ratio?
A gearing ratio below 50% is generally considered safe, but it depends on the industry. Lower ratios indicate lower financial risk, while higher ratios suggest greater reliance on debt.
Can a high gearing ratio be a good thing?
Yes, if the borrowed money is used effectively to generate higher profits. However, too much debt increases financial risk, especially during downturns.
How often should businesses check their gearing ratio?
Small businesses should review their gearing ratio at least quarterly to ensure they are not over-reliant on debt.
How does the gearing ratio affect business loans?
Banks and lenders check the gearing ratio before approving loans. A high ratio might make borrowing difficult, while a balanced ratio improves loan eligibility.
What can businesses do if their gearing ratio is too high?
Businesses can reduce high-interest debt, reinvest profits, negotiate better loan terms, and seek alternative funding sources like investors or government grants.
Conclusion #
The gearing ratio is a key financial tool for small businesses in India. It helps track debt levels, make smarter financial choices, and attract investors. By keeping debts manageable and profits growing, businesses can stay financially strong.