Gearing

What Is Gearing?

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 extent of debt-to-equity is great, then a business might be considered being highly geared, or highly leveraged.

Understanding Gearing

Gearing is measured by a number of ratios — including the D/E ratio, shareholders' equity ratio, and debt-service coverage ratio (DSCR) — which indicate the level of risk associated with a specific 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 gearing ratio of 70% may be very manageable for a utility company — as the business capabilities as a monopoly with support from neighborhood government channels — however it could be excessive for a technology company, with intense competition in a rapidly evolving marketplace.

Special Considerations

Gearing, or leverage, helps to determine a company's creditworthiness. Lenders might consider a business' gearing ratio when deciding whether to extend it credit; to which a lender could add factors like whether the loan would be supported with collateral, and in the event that the lender would qualify as a "senior" lender. With this data, senior lenders could choose to remove short-term debt obligations when working out the gearing ratio, as senior lenders receive priority in the event of a business' bankruptcy.

In cases where a lender would be offering an unsecured loan, the gearing ratio could include data about the presence of senior lenders and preferred stockholders, who have certain payment guarantees. This permits the lender to adjust the calculation to reflect the higher level of risk than would be present with a secured loan.

Gearing versus Risk

In general, a company with excessive leverage, demonstrated by its high gearing ratio, could be more vulnerable to economic downturns than a company that is not as leveraged, because a highly leveraged firm must make interest payments and service its debt through cash flows, which could decline during a downturn. Then again, the risk of being highly leveraged functions admirably during good economic times, as each of the excess cash flows accrue to shareholders once the debt has been paid down.

Example of Gearing

As a simple illustration, to fund its expansion, XYZ Corporation can't sell additional shares to investors at a reasonable price; so instead, it gets a $10,000,000 short-term loan. Currently, XYZ Corporation has $2,000,000 of equity; so the debt-to-equity (D/E) ratio is 5x — [$10,000,000 (total liabilities) divided by $2,000,000 (shareholders' equity) equals 5x]. XYZ Corporation definitely would be considered highly geared.

Highlights

• On the off chance that a company has high leverage ratios, it very well may be considered being highly geared.
• The appropriate level of gearing for a company depends on its sector and the degree of leverage of its corporate peers.
• Gearing can be considered leverage, where it's measured by different leverage ratios, like the debt-to-equity (D/E) ratio.