What does the gearing ratio measure?

The gearing ratio is a financial metric that measures the proportion of a company's debt relative to its equity, specifically focusing on the level of financial leverage within the company. The correct formula for the gearing ratio is debt divided by the total of debt plus equity. This calculation helps to assess how much of the company's financing comes from debt compared to equity, which is essential for understanding the risk level associated with the company's capital structure.

When referencing this ratio, a higher gearing ratio often indicates greater financial risk, as it implies that a larger proportion of the company is financed through debt. Conversely, a lower gearing ratio typically suggests a more conservative financing strategy that relies more on equity. This insight is crucial for stakeholders, such as investors and creditors, as it can impact their decisions regarding the company's creditworthiness and investment appeal.

Understanding the gearing ratio enables analysts and management to evaluate financial stability and potential vulnerabilities related to interest payments and debt obligations during varying economic conditions.