The most common use of the term ‘gearing’ is to describe the level of a company’s debt compared with its equity capital, and usually, it is expressed as a percentage. So a company with gearing of 60 per cent has levels of debt which are 60 per cent of its equity capital.
The significance of the gearing ratio is that it shows at a glance how encumbered a company is with debt. Depending on the industry, a gearing ratio of 15% would be considered prudent whilst anything over 100% would be considered risky or ‘highly geared’.
‘Gearing’ is also used in a related sense to refer to borrowings by an investment trust which boosts the return on capital and income via additional investment. When the trust is performing well shareholders enjoy an enhanced or ‘geared profit’. However, if the trust performs poorly then the loss is similarly exaggerated.
Finally, ‘gearing’ is also used to refer to the ratio between a company’s share price and its warrant price.
The ratio of a company’s long-term funds with fixed interest to its total capital. A high gearing is generally considered very speculative.
Gearing appraises the extent to which a specific company is funded by debt. It is a general financial term that compares borrowed funds and the amount of liquidity held by the company owner. Gearing demonstrates the point to which activities of a company are funded by owner’s funds compared to funds given by creditors. Gearing is also known as leverage in North America.
The gearing of a specific company can be found out by using the following formula:
Gearing= debt/ (debt + shareholder’s funds)
A high gearing in a company translates into a risky investment. Investment in a particular company according to its gearing is judged by comparing the company’s debt-to-equity ratio with its peer companies in the same market.
Gearing can be calculated by a number of methods. These methods include: debt ratio (total debt / total assets), times interest earned (EBIT / total interest), debt-to-equity ratio (total debt/ total equity) and equity ratio (equity / assets). A debt of more than 50% of its total capital is considered risky.
Companies having higher gearings are more susceptible to the business cycle. This is due to the fact that the companies must pay off their debts regardless of their performance in the market.
Equity
It is a kind of security that represents an ownership interest. Equity is described in a company’s balance sheet as the quantum of funds invested by the owners (including stockholders) and also takes into account the retained earnings or losses.
Business Cycle
A business cycle is described as fluctuating economic activity that an economy undergoes over a long time period. Any business cycle has 5 stages: expansion or growth, peak, contraction or recession, trough and recovery. Business cycles vary in duration and magnitude.
Times Interest Earned
It is a metric to assess the ability of a company to cope with its debt obligations. Times Interest Earned (TIE) is computed by picking a specific company’s earnings before interest and taxes (EBIT) and dividing the same by the total payable interest on contractual debt like bonds. TIE is usually cited as a ratio.
Gearing is a ratio that is used to quantify a business’s financial leverage. Gearing is a measure of the proportion of financing provided by lenders to that provided by shareholders. It expresses a company’s debt level as a percentage of its equity capital. It is a fundamental analysis ratio that indicates how much long-term debt a business has in comparison to its equity capital. For instance, a gearing ratio of 60% indicates that debts account for 60% of the company’s equity capital.
Gearing can be measured in a variety of ways, including:
- Ratio of debt to equity
- Debt service to income ratio
- Equity to debt ratio
- The debt-to-shareholders’-funds ratio
It may, for example, be a ratio of a company’s stock price to the price of its warrants.
In essence, the gearing ratio shows a company’s debt burden. The optimum level of gearing for a firm is determined by the sector to which it belongs as well as the degree of leverage used by its peers. Each company will have a separate level.
High gearing ratios are preferred by firms in industries with large and ongoing fixed asset requirements, whereas organisations in cyclical industries prefer low gearing ratios. This is not necessarily a prudent money management strategy. Firms with more reliable operating profits can comfortably take on more debt.
The effect of gearing on profit volatility can be studied using the interest curve. A high gearing ratio is a source of concern for lenders and creditors since it makes it difficult for these companies to meet debt repayment schedules during business downturns. Profits for shareholders become more erratic as debt levels rise.
A company’s gearing ratio can be reduced by selling shares to pay down debt, converting debts into shares, or reducing working capital.
This site contains general legal information but does not constitute professional legal advice for your particular situation. Persuing this glossary does not create an attorney-client or legal adviser relationship. If you have specific questions, please consult a qualified attorney licensed in your jurisdiction.
This glossary post was last updated: 29th March 2024.
To help you cite our definitions in your bibliography, here is the proper citation layout for the three major formatting styles, with all of the relevant information filled in.
- Page URL:https://dlssolicitors.com/define/gearing/
- Modern Language Association (MLA):Gearing. dlssolicitors.com. DLS Solicitors. May 09 2024 https://dlssolicitors.com/define/gearing/.
- Chicago Manual of Style (CMS):Gearing. dlssolicitors.com. DLS Solicitors. https://dlssolicitors.com/define/gearing/ (accessed: May 09 2024).
- American Psychological Association (APA):Gearing. dlssolicitors.com. Retrieved May 09 2024, from dlssolicitors.com website: https://dlssolicitors.com/define/gearing/
Our team of professionals are based in Alderley Edge, Cheshire. We offer clear, specialist legal advice in all matters relating to Family Law, Wills, Trusts, Probate, Lasting Power of Attorney and Court of Protection.
All author posts