Gearing

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Gearing

Gearing, also called leverage, is the extent to which a company finances its operations with debt versus equity. It shows how much of a firm’s capital comes from lenders compared with shareholders and is a core indicator of financial risk and creditworthiness.

Why gearing matters

  • Indicates financial risk: higher gearing means more fixed obligations (interest and principal) that must be met from cash flows.
  • Affects credit decisions: lenders and rating agencies use gearing (and related adjustments for collateral and debt seniority) when assessing whether to extend credit and on what terms.
  • Amplifies outcomes: in good times high gearing can boost returns to equity holders once debt costs are covered; in downturns it increases insolvency risk.

Key measures of gearing

Common ratios used to quantify gearing include:

  • Debt-to-Equity (D/E) ratio
    Formula: D/E = Total liabilities / Shareholders’ equity
    Interprets how many dollars of debt exist for each dollar of equity.

  • Equity (shareholders’ equity) ratio
    Formula: Equity ratio = Shareholders’ equity / Total assets
    Measures the portion of assets financed by owners rather than creditors.

  • Debt-Service Coverage Ratio (DSCR)
    Formula: DSCR = Operating income available for debt service / Debt service (principal + interest)
    Assesses the company’s ability to meet periodic debt obligations from operating cash flow.

Different stakeholders may adjust these calculations—for example, excluding certain short-term items, treating preferred stock differently, or accounting for secured vs unsecured debt—depending on the credit context.

Example

If a company takes a $10,000,000 loan and has $2,000,000 of shareholders’ equity, its D/E ratio is 5× (10,000,000 / 2,000,000). That indicates high gearing and greater financial leverage.

Sector and peer context

There is no universal “right” level of gearing. Acceptable leverage depends on:

  • Industry characteristics (stable, regulated businesses such as utilities often tolerate higher gearing; early-stage or highly competitive sectors like technology generally require lower gearing).
  • Comparison with peer companies and common lending practices in the sector.
  • The company’s cash-flow stability and collateral support.

For example, a gearing ratio of 70% might be manageable for a regulated utility but excessive for a fast-changing tech firm.

Lender perspective and special considerations

Lenders evaluate gearing alongside other factors:

  • Collateral and loan seniority: secured or senior lenders have priority in bankruptcy, which affects perceived risk and how gearing is interpreted.
  • Presence of preferred stock or other creditor-like claims, which can influence the effective capital cushion.
  • Adjustments for short-term obligations or off-balance-sheet items when assessing true debt exposure.

Unsecured lenders typically demand a more conservative view of gearing because they lack repayment priority and collateral.

Gearing versus risk

  • Upside: When earnings exceed borrowing costs, leverage amplifies returns to equity holders.
  • Downside: Leverage magnifies losses and increases the chance of default when cash flows decline, making highly geared firms more vulnerable in downturns.

Takeaways

  • Gearing measures financial leverage: how much debt funds a company relative to equity.
  • D/E ratio, equity ratio, and DSCR are common measures.
  • Appropriate gearing varies by industry, cash-flow stability, and peer norms.
  • Lenders adjust gearing assessments for collateral, seniority, and the nature of claims.
  • High gearing can boost returns in good times but increases insolvency risk in bad times.