Gearing is the ratio of the funds borrowed by the company to its equity. This term is of a high importance as it measures the level of investments made by lenders (also defined as financial leverage). If the debt-to-equity (D/E) ratio is high, it means that the company can be described as highly geared.
When calculating gearing, the following ratios are used:
- D/E ratio;
- Shareholders' equity ratio;
- Debt-service coverage ratio (DSCR).
They demonstrate whether financial risks concerning an enterprise are significant. An area of the economy the organization operates in and the degree of leverage of organizations that work in the same sector influence the firm’s gearing ratio.
For instance, if a gearing value of the company is 60%, it indicates that the amount of leverage used is 60% of the equity. This may work for a company that provides water, electricity or gas services and that is supported mainly by the government funds, while a tech firm should have a lower ratio to be competitive in the market.
If an organization’s debt is $4 billion and it holds $2 billion in shareholder equity, the coefficient of gearing is 2. This value is considered to be a high gearing ratio.
Importance of Gearing
Gearing can indicate whether an organization is creditworthy or not. Individuals, groups, institutions that lend money can pay attention to a gearing ratio when offering credit. They can also take into consideration such factors as the availability of a collateral for the loan and qualification of a lender.
If a bank or other lender offers an unsecured loan, the ratio can contain the details about senior lenders and preferred stockholders with specific payment guarantees. It gives the lender an opportunity to adjust the calculation to evaluate risks.
Risks of Excessive Leverage
It is generally accepted that the high coefficient of gearing increases the risk of bankruptcy. But for some companies high values are acceptable.
High level of borrowed capital and, consequently, high ratio increases the risks of non-payment of the company. The bigger the debt is, the more the company depends on lenders and their funds and the more sensitive it is to recession. Such organizations are obliged to make interest payments and repay the debt with the help of cash flows that may decrease during a recession.