What Is Gearing?
Gearing is the ratio of a company’s debt-to-equity (D/E). Gearing analyzes a company’s financial leverage—how much lenders support its operations against its shareholders. A highly geared or leveraged firm has a high debt-to-equity ratio.
Understanding Gearing
The D/E ratio, shareholders’ equity ratio, and debt-service coverage ratio (DSCR) assess gearing, indicating company risk. A company’s gearing relies on its sector and its peers’ leverage.
For instance, a 70% gearing ratio indicates a company’s debt levels are 70% of its equity. A utility firm, which operates as a monopoly with local government backing, may be able to maintain a 70% gearing ratio. Still, a technological company in a fast-changing market may not.
Special Considerations
Gearing—leverage—affects a company’s creditworthiness. Lenders may examine a business’s gearing ratio when extending credit and consider factors like collateral and “senior” status. With this information, senior lenders may exclude short-term loan obligations from the gearing ratio since they have priority in a business’s insolvency.
If a lender offers an unsecured loan, the gearing ratio may contain information about senior lenders and preferred shareholders who guarantee payments. The lender might change the computation to reflect the greater risk compared to a secured loan.
Gearing vs. Risk
A company with a high gearing ratio may be more vulnerable to economic downturns due to the need to make interest payments and service debt, which can decrease cash flows during a downturn. During favorable economic times, highly leveraged companies benefit from surplus cash flows to shareholders after paying the debt.
A Gearing Example
For instance, XYZ Corporation cannot sell more shares to investors at a fair price, so it takes out a $10,000,000 short-term loan to expand. The D/E ratio for XYZ Corporation is 5x, calculated by dividing its total liabilities ($10,000,000) by its shareholders’ equity ($2,000,000). XYZ Corporation is well-geared.
Conclusion
- Leverage ratios like the debt-to-equity (D/E) ratio quantify gearing.
- A highly-geared corporation has high leverage ratios.
- A company’s gearing relies on its sector and its peers’ leverage.
