Gearing Ratios

Total Gearing = Total Liabilities / Tangible Net Worth

- Bank Gearing = Total Bank Liabilities / Tangible Net Worth

- Short Term Debt/Working Capital = Short Term Bank Debt / (Stocks + Trade Debtors – Trade Creditors)

All other things being equal, the higher the Total Gearing the less secure the business is in the face of future adversity. However, all other things are never equal and we should not think that there is one level of gearing that is appropriate for all firms in all circumstances.

Firms with a high level of sustainable profits and the ability to generate cash can sustain quite high levels of gearing without undue risk. On the other hand, highly geared firms that are not particularly profitable are in severe danger if creditors withdraw their support.

If Total Gearing increases over time we would hope to see that this was the result of deliberate policy by management of investment in assets that will yield good profits and cash flow in the near future.

The interpretation of Bank Gearing is similar to Total Gearing. It highlights the relative contributions of banks and the owners to financing the business.

Apart from being vulnerable to changes in existing profit and cash generating ability, a company with high Bank Gearing will also be vulnerable to interest rate changes.

As a back up to this ratio, banks often calculate the extent to which operating profit covers interest on borrowing.

The final gearing ratio in Slide?? measures the extent to which bank short term debt is funding net working capital at Balance Sheet date. As a general rule, we would not like to see this ratio too near 100%.