GEARING

Definition

Gearing refers to the financial leverage of a company, measuring the extent to which it uses debt financing relative to equity to fund its operations and growth. High gearing means a company relies heavily on borrowed money; low gearing indicates greater reliance on shareholders' funds.

Gearing is used to assess financial risk, capital structure, and a firm’s sensitivity to economic volatility.

Origins

The term “gearing” is more commonly used in UK, Commonwealth, and IFRS-based reporting systems, while “leverage” is its U.S. counterpart. It became widely analyzed with the development of capital structure theory, notably Modigliani and Miller’s propositions (1958), which laid the foundation for debt-equity optimization.

Usage

Industry Applications:

• Corporate Finance – Capital structure optimization.

• Banking – Credit risk assessment for loan underwriting.

• Private Equity – Leveraged buyout (LBO) modeling.

• Investment Research – Assessing risk/reward profile of equity.

• Debt Capital Markets (DCM) – Evaluating debt capacity and covenant compliance.

How Gearing works

Gearing Measures:

1. Capital Gearing Ratio:

   $$\text{Gearing Ratio} = \frac{\text{Debt}}{\text{Equity} + \text{Debt}}$$

2. Debt-to-Equity Ratio:

   $$\text{Debt-to-Equity} = \frac{\text{Total Debt}}{\text{Shareholders’ Equity}}$$
   

3. Net Gearing:

   $$\text{Net Gearing} = \frac{\text{Net Debt}}{\text{Shareholders’ Equity}} = \frac{\text{Debt} - \text{Cash}}{\text{Equity}}$$

4. Interest Cover (to assess serviceability):

   $$\text{Interest Coverage Ratio} = \frac{\text{EBIT}}{\text{Interest Expense}}$$

Gearing in Practice:

• High Gearing → Higher interest obligations, higher risk in downturns.

• Low Gearing → Financial flexibility but potentially under-leveraged returns.

Key Takeaways

• Gearing reflects how risky and aggressive a company's financing is.
• Affects EPS volatility, cost of capital, and bankruptcy risk.
• Optimal gearing balances growth funding with manageable risk.
• High gearing is typical in infrastructure, utilities, LBOs; low gearing in tech, startups.

Types of Gearing

Gearing & Financial Modeling

Gearing directly affects:

• WACC Calculation: Changes cost of capital mix (debt cheaper than equity but adds risk).

• EPS Forecasts: More debt = higher EPS sensitivity to EBIT swings.

• Debt Covenants: Modeled to avoid breaches of max gearing or interest cover.

• Valuation Models:

  • EV remains debt-agnostic, but equity value is impacted.

  • Leveraged Free Cash Flow (LFCF) modeling depends on gearing structure.

Nuances & Complexities

• Industry Benchmarks: Utilities may have high gearing (stable cash flows); SaaS firms are often low-geared.

• Market Conditions: Rising interest rates increase refinancing risk for highly geared firms.

• Non-Financial Liabilities: Sometimes overlooked gearing risks include pension deficits and lease liabilities (IFRS 16).

• Hybrid Instruments: Preferred stock and convertible debt may complicate pure debt/equity ratios.

• Country Differences: U.S. reports focus more on debt-to-EBITDA and interest coverage; UK focuses on gearing ratios.

Mathematical Formulas

Related Terms

• Leverage

• Capital Structure

• Cost of Capital

• Debt-to-Equity Ratio

• EBIT

• WACC

• Covenant

• Debt Servicing Ratio

   

  Real-World Applications

  1. Leveraged Buyouts (LBOs)

  PE firms use high gearing (60–90% debt) to magnify returns. The exit equity value depends on de-gearing and EBITDA growth.

  2. Utility Companies

  High gearing (~60–70%) is accepted due to regulated revenue, stable cash flows, and government oversight.

  3. Corporate Ratings

  Credit rating agencies evaluate gearing in debt rating assessments. A BBB-rated firm increasing gearing may face a downgrade.

  4. Financial Covenants

  Banks require that companies maintain net gearing below thresholds (e.g., < 1.5x) as part of loan agreements.

References & Sources

• IASB/IFRS Standards – IFRS 7 & IFRS 9 for debt disclosure

• Modigliani & Miller (1958) – Capital Structure Irrelevance Theorem

• OECD Corporate Finance Studies – Gearing and Enterprise Risk