Financial gearing measures the relative amount of debt in a firm's capital structure.
The greater the gearing, the greater the total financial risk.
Gearing is sometimes also known as leverage.
Appropriate levels of gearing depend mostly on the stability of operational cash flows.
The more stable the cash flows, the greater the level of gearing that can safely be accepted by the firm.
Firms with less stable cash flows should have lower levels of gearing, or none, or even negative gearing (net cash surpluses).
Gearing and leverage ratios can be calculated in several different ways, so consistency of approach is important.
Two essential bases to define are:
i. The use of book or market values.
ii. The use of Debt divided by Equity (D/E) or of Debt divided by Debt plus Equity = D / (D+E).
Example 1: Calculation of gearing
Assume the values of debt and equity are equal, say USD 1m each.
D/E = 1/1
The 100% figure is usually known as 'gearing'.
Example 2: Calculation of leverage
Using the other calculation with the same inputs (D = 1 and E = 1):
D / (D+E) = 1/2
The 50% figure is usually known as 'leverage'.
Adjustments to D and E figures
With respect to the Debt figure, practice varies in including or excluding certain items such as cash, short term borrowings, leases, pensions and other provisions.
Practitioners may also adjust the Equity figure, for example to exclude intangible assets.
Expression of gearing figures
Gearing may be expressed as a percentage (eg 100%), a number (eg 1) or a proportion (eg 1:1).
Operational gearing relates to the operating costs of a business, and measures the relative proportions of fixed and variable operating costs.
The higher the proportion of fixed costs, the higher the operational gearing, and the higher the risk being undertaken by the business.
'Gearing up' refers to increasing the levels of financial or operation gearing - or both - within an organisation.
The intention of gearing up is to improve expected net results.
A consequence of gearing up is normally to increase risk, and the cost of equity capital.
Many financial disasters have been a consequence of gearing up (or leveraging) excessively in this way in earlier periods.
- Balance sheet ratio
- Basel III
- Cost of equity
- Debt equity ratio
- Debt to equity ratio
- Geared beta
- Guide to risk management
- Intangible assets
- Interest cover
- Leverage Ratio
- Leveraged takeover
- Levered beta
- Long-term solvency ratio
- Off balance sheet finance
- Tax shield
- Ungeared cash flow