Gearing

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1.
Financial gearing measures the relative amount of debt in a firm's capital structure.
Gearing is sometimes also known as leverage.


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

Gearing
Assume the values of debt and equity are equal, say USD 1m each.
D/E = 1/1

= 100%.

The 100% figure is usually known as 'gearing'.


Example 2: Calculation of leverage

Leverage
Using the other calculation with the same inputs (D = 1 and E = 1):
D / (D+E) = 1/2

= 50%.

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.


Bank supervision
In the banking context, the calculation of the regulatory Leverage Ratio is strictly specified, following Basel III.


Expression of gearing figures
Gearing may be expressed as a percentage (eg 100%), a number (eg 1) or a proportion (eg 1:1).


2.
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
'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.


See also


Other links

Masterclass: Measuring financial risk, Will Spinney, The Treasurer