What is ‘Gearing’
Gearing refers to the level of a company’s debt related to its equity capital, usually expressed in percentage form. It is a measure of a company’s financial leverage and shows the extent to which its operations are funded by lenders versus shareholders. The term “gearing” also refers to the ratio between a company’s stock price and the price of its warrants.
Explaining ‘Gearing’
Gearing can be measured by a number of ratios, including the debt-to-equity ratio, equity ratio and debt-service ratio. The ratios serve as indicators regarding the level of risk associated with a particular business. The appropriate level of gearing for a company depends on its sector, as well as the degree of leverage employed by its peers. For example, a gearing ratio of 70% shows that a company’s debt levels are 70% of its equity. A gearing ratio of 70% may be very manageable for a utility, as the business functions as a monopoly with support through local government channels, but it may be far too much for a technology company with high levels of competition in a rapidly changing marketplace.
Use of Gearing Ratios
Lenders may consider a business’s gearing ratio when determining whether to extend credit. This information can be combined with whether or not the loan will be supported with collateral, as well as if the lender will qualify as a senior lender should the business fail. With this in mind, senior lenders may choose to remove short-term debt obligations when calculating the gearing ratio, as senior lenders receive priority in case of the business’s bankruptcy.
Gearing Ratio and Risk
In general, a company with excessive leverage, as demonstrated by its high gearing ratio, may be more vulnerable to economic downturns. This is because it has to make interest payments and service its debt through cash flows that may be significantly lower due to the downturn. The flip side of this argument is that leverage works well during good times, since all the excess cash flows accrue to shareholders once the debt service payments have been made.
Further Reading
- An investment strategy based on gearing ratio – www.tandfonline.com [PDF]
- The demand for external auditing: managerial share ownership, size, gearing and liquidity influences – www.emerald.com [PDF]
- Discourses around negative gearing of investment properties in Australia – www.tandfonline.com [PDF]
- Gearing up for personalisation: training activities commissioned in the English pilot individual budgets sites 2006–2008 – www.tandfonline.com [PDF]
- Equity Financing and Gearing in the UK, US, Japan, and Israel – www.jstor.org [PDF]
- Gearing service quality into public and private hospitals in small islands – www.emerald.com [PDF]
