What is Gearing?

Gearing is a comparison of the debt and equity invested in a business. The comparison is used to determine the extent to which a business is relying upon riskier debt to fund its operations. For example, a business has $250,000 of debt and $750,000 of equity. The entity is considered to have 33% gearing.

There is no ideal gearing level. A business in one industry might have a 50% debt to equity ratio and be considered highly geared, while a business in another industry might have an 80% ratio and yet not be considered highly geared. The key difference is in the stability of the underlying cash flows. For example, a utility is typically in a monopoly position, and so has highly regular cash flows. This entity can afford to sustain a high debt level, since it can always make the related debt payments. Conversely, a consumer electronics business experiences heavy competition and short product life cycles, and so cannot be assured of the cash flows needed to pay off its debt.

Gearing can work very well during upturns in a business market, since sales and cash flows are increasing. In this situation, management can take on more debt to fund operations or buy back shares, resulting in increased earnings per share. Conversely, in a down market, sales and cash flows decline, and a larger proportion of profits must be used to pay for the interest expense associated with debt.

Types of Gearing Ratios

There are several ratios available for measuring gearing, including the debt to equity ratio, debt service ratio, and equity ratio. The debt to equity ratio compares the recorded amount of all debt on an organization’s balance sheet to the total amount of its equity, to see if its debt obligations are too high. This will depend on the consistency of its cash flows, as well as the interest rate on the debt.

The debt service ratio compares an organizations cash flows to its debt obligations, to see if it has sufficient cash to pay for its debts. This ratio is more meaningful than the debt to equity ratio, since it gives a more nuanced view of a firm’s ability to pay. However, it does not account for any looming debt balloon payments.

The equity ratio compares the total equity of a business to its total assets. If the outcome of the calculation is high, this implies that management has minimized the use of debt to fund its asset requirements, which represents a conservative way to run the entity. In the reverse situation, it implies that management has used a significant amount of debt to fund asset purchases.