Gearing Definition & Overview

KEY TAKEAWAYS

• Gearing can typically get viewed as a type of leverage. It’s measured using different leverage ratios such as the debt-to-equity (D/E) ratio.
• Gearing levels can differ depending on the type of company, the industry it’s in, and the degree of leveraging other businesses have.
• When a business has a high leverage ratio, it’s known as being highly geared.

What Is Gearing? 

To keep things simple, understanding gearing is basically the ratio of a company’s debt-to-equity. It’s the total amount of debt that a company uses to fund operations in proportion to its equity capital. If a business that has a high gearing ratio also has a high debt-to-equity ratio, it might indicate the risk of financial failure. 

Gearing is an effective way to measure how much a company funds its operations using borrowed money. This money can often come from lenders, and it’s usually instead of money that’s sourced from its shareholders. 

What Is the Benefit of Gearing?

Depending on the company and the type of investment wanting to be made, gearing can bring a few benefits. Here are some of the most common ones. 

• Less income tax payments — Sometimes, interest and other costs of gearing could become tax-deductible. Ultimately, this can help reduce your taxable income. 
• More wealth accumulation — Gearing can help with accelerating wealth since a larger amount of money can get invested. This is compared to having to use your own money.
• You can utilize existing equity — When investing, borrowing against an existing portfolio might provide the opportunity to unlock more equity. This can lead to a larger and more diversified portfolio of investments. 

How Are Gearing Ratios Used?

The way that gearing ratios are used depends on a few factors, including if they’re being used by lenders, investors, or as a simple comparison tool. 

Lenders often use gearing ratios to make a more informed decision about if they’re going to extend credit or not. They’re also going to use it to help figure out if a borrower can repay a loan. 

Investors use gearing ratios to help gain insights into a company and determine if it’s going to be a good investment. If a company has a strong and stable balance sheet and low gearing ratios, investors will often find this appealing. As well, if an investor determines a company to have a high gearing ratio, they might think the investment is risky. 

Aside from lenders and investors, gearing ratios are also valuable as a comparison tool. They help to evaluate and determine the overall performance of companies in the same industry. A gearing ratio on its own isn’t always going to tell the whole story. 

For example, a company that has a gearing ratio of 70% might look as though it’s high, meaning a potentially risky investment. Yet, if you compare that same company against another company that has a gearing ratio of 90%, the first company could be an optimal investment. 

Types of Gearing Ratios 

There are several different types of gearing ratios that you can use. These can come in handy when measuring the level of financial risk a company has. Here are the most common types of gearing ratios:

• Equity ratio
• Debt-to-capital ratio
• Debt service ratio
• Debt to shareholders funds ratio
• Debt to equity ratio

Gearing Ratio and Risks

Whether a company has a high or low gearing ratio can show insights into potential financial risks. Having a high gearing ratio can indicate that a company has high leverage. If this is the case, it means that it could be negatively affected by potential downturns in the economy. 

This could mean they face the risk of default or financial failure. With limited cash flows, it can lead to difficulty in meeting operational costs and making debt payments. 

On the flip side, a company that has a low gearing ratio is often considered to be financially sound and stable. That said, it doesn’t always mean that the company has a healthy capital structure. For example, a business that’s capital intensive or cyclical might not always be able to finance operations by using shareholder equity. 

They’re going to need to get financing in another form to be able to continue to stay in operation. 

What Is an Example of Gearing?

Before getting into the example, it’s first worth understanding how to calculate the gearing ratio. The formula would look like this: 

Let’s say that a company wants to find out if they’re highly geared or not. They have $200 million of debt and have just over $100 million in shareholder equity. Ultimately, this would mean that they have a gearing ratio of 200%, or 2. 

So, the company has double the debt than they do shareholder equity, which means it’s highly geared. 

Summary

Gearing is a ratio used to determine a company’s debt-to-equity. It can be an effective ratio for lenders and investors to use, and it’s also a good comparison tool. Gearing shows and measures how much a company funds its total operations using borrowed money instead of money from shareholders.