Gearing refers to the relationship, or ratio, of a company’s debt-to-equity (D/E). Gearing shows the extent to which a firm’s operations are funded by lenders versus shareholders — in other words, it measures a company’s financial leverage. When the proportion of debt-to-equity is great, then a business may be thought of as being highly geared or highly leveraged.
Key Takeaways
- Gearing equals leverage: It’s measured by various leverage ratios, such as the debt-to-equity (D/E) ratio.
- High leverage ratios signify high gearing: Companies with high leverage ratios are considered highly geared.
- Sector-specific gearing levels: The appropriate level of gearing for a company depends on its sector and the degree of leverage of its corporate peers.
Understanding Gearing
Gearing is measured by multiple ratios — including the D/E ratio, shareholders’ equity ratio, and debt-service coverage ratio (DSCR) — which indicate the level of risk associated with a particular business. The appropriate level of gearing for a company depends on its sector and the degree of leverage of its corporate peers.
For example, a gearing ratio of 70% shows that a company’s debt levels are 70% of its equity. A 70% gearing ratio might be very manageable for a utility company — as the business functions as a monopoly with support from local government channels — but it may be excessive for a technology company, facing intense competition in a rapidly changing marketplace.
Special Considerations
Gearing, or leverage, helps to determine a company’s creditworthiness. Lenders may consider a business’s gearing ratio when deciding whether to extend it credit; additional factors include the presence of collateral and the lender’s seniority status. For example, senior lenders might choose to exclude short-term debt obligations when calculating the gearing ratio, as they receive priority in the event of a business’s bankruptcy.
In the case of unsecured loans, the gearing ratio might account for the presence of senior lenders and preferred stockholders, who have certain payment guarantees. This allows the lender to adjust calculations to reflect a higher risk level than would be present with a secured loan.
Gearing vs. Risk
Generally, a company with excessive leverage, indicated by a high gearing ratio, is more vulnerable to economic downturns than a less leveraged company. A highly leveraged firm must make interest payments and service its debt via cash flows, which could decline during downturns. Conversely, during good economic times, the risk of being highly leveraged can be beneficial, as excess cash flows accrue to shareholders once the debt is paid down.
Example of Gearing
To illustrate, consider XYZ Corporation needing funds to expand. Unable to sell additional shares at a reasonable price, it opts for a $10,000,000 short-term loan. XYZ Corporation currently has $2,000,000 of equity, leading to a debt-to-equity (D/E) ratio of 5x
[$10,000,000 (total liabilities) ÷ $2,000,000 (shareholders' equity) = 5x]
XYZ Corporation would be considered highly geared.
Related Terms: debt-to-equity ratio, financial leverage, equity ratio, debt-service coverage ratio, creditworthiness.
