What is Gearing
Gearing refers to the level of a company’s debt related to its equity capital, usually expressed in percentage form. It is a measure of a company’s financial leverage and shows the extent to which its operations are funded by lenders versus shareholders. The term "gearing" also refers to the ratio between a company’s stock price and the price of its warrants.
BREAKING DOWN Gearing
Gearing can be measured by a number of ratios, including the debt-to-equity ratio, equity ratio and debt-service ratio. The ratios serve as indicators regarding the level of risk associated with a particular business. The appropriate level of gearing for a company depends on its sector, as well as the degree of leverage employed by 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, as the business functions as a monopoly with support through local government channels, but it may be excessive for a technology company with high levels of competition in a rapidly changing marketplace.
Use of Gearing Ratios
Lenders may consider a business’s gearing ratio when determining whether to extend credit. This information can be combined with whether or not the loan will be supported with collateral, as well as if the lender will qualify as a senior lender should the business fail. With this in mind, senior lenders may choose to remove short-term debt obligations when calculating the gearing ratio, as senior lenders receive priority in case of the business’s bankruptcy.
In cases in which a lender would be offering an unsecured loan, the gearing ratio may include information regarding the presence of senior lenders as well as preferred stockholders that have certain payment guarantees. This allows the lender to adjust the calculation to reflect the higher level of risk than would be present with a senior lender.
Gearing Ratio and Risk
In general, a company with excessive leverage, as demonstrated by its high gearing ratio, may be more vulnerable to economic downturns. That's because it must make interest payments and service its debt through cash flows that may decline during the downturn. The flip side of this argument is that leverage works well during good times, since all the excess cash flows accrue to shareholders once the debt service payments have been made.
In contrast, lower leverage does not guarantee sound financial management on the part of the business. Certain industries that are highly cyclical in nature, such as those with significant seasonal variances, may not have the funds available year-round to meet debt obligations over a specific amount. This could include businesses in certain agricultural sectors as well as those tied to fluctuating seasonal demands, such as garden centers.