The challenge with gearing, is that when a banker mentions it, you don’t actually know what they’re talking about as it has a couple of different versions which result in very different results. In principle, it always relates to the proportion of debt that is used to fund the development of a business, but the methodology varies. We cover three below, but there are others that will occasionally rear their head. Lenders use this ratio as it is an indicator of how much “skin in the game” the investors have in the business – high ratios indicate that debt is largely funding the business, and equity does not have much to lose if the business fails, and is therefore seen as less likely to stay involved and fix any problems that may arise.
Debt / (Debt + Equity)
This method measures debt as a proportion of total capital funding contributed.
Debt / Equity
This method measures debt as a proportion of equity. Equity could be the amount of equity contributed, or adjusted for retained profits/losses.
Debt / Assets
This method measures debt as a proportion of total assets. The ratio will therefore be lower if suppliers are used to fund the business (i.e. delaying payments to assist with business funding).