Gearing

Business, Legal & Accounting Glossary

Definition: Gearing


Quick Summary of Gearing


The most common use of the term ‘gearing’ is to describe the level of a company’s debt compared with its equity capital, and usually, it is expressed as a percentage. So a company with gearing of 60 per cent has levels of debt which are 60 per cent of its equity capital.

The significance of the gearing ratio is that it shows at a glance how encumbered a company is with debt. Depending on the industry, a gearing ratio of 15% would be considered prudent whilst anything over 100% would be considered risky or ‘highly geared’.

‘Gearing’ is also used in a related sense to refer to borrowings by an investment trust which boosts the return on capital and income via additional investment. When the trust is performing well shareholders enjoy an enhanced or ‘geared profit’. However, if the trust performs poorly then the loss is similarly exaggerated.

Finally, ‘gearing’ is also used to refer to the ratio between a company’s share price and its warrant price.




Full Definition of Gearing


Gearing appraises the extent to which a specific company is funded by debt. It is a general financial term that compares between borrowed funds and the amount of liquidity held by the company owner. Gearing demonstrates the point to which activities of a company are funded by owner’s funds compared to funds given by creditors. Gearing is also known as leverage in North America.

The gearing of a specific company can be found out by using the following formula:

Gearing= debt/ (debt + shareholder’s funds)

A high gearing in a company translates into a risky investment. Investment in a particular company according to its gearing is judged by comparing the company’s debt-to-equity ratio with its peer companies in the same market.

Gearing can be calculated by a number of methods. These methods include: debt ratio (total debt / total assets), times interest earned (EBIT / total interest), debt-to-equity ratio (total debt/ total equity) and equity ratio (equity / assets). A debt of more than 50% of its total capital is considered risky.

Companies having higher gearings are more susceptible to the business cycle. This is due to the fact that the companies must pay off their debts regardless of their performance in the market.

Equity

It is a kind of security that represents an ownership interest. Equity is described in a company’s balance sheet as the quantum of funds invested by the owners (including stockholders) and also takes into account the retained earnings or losses.

Business Cycle

A business cycle is described as fluctuating economic activity that an economy undergoes over a long time period. Any business cycle has 5 stages: expansion or growth, peak, contraction or recession, trough and recovery. Business cycles vary in duration and magnitude.

Times Interest Earned

It is a metric to assess the ability of a company to cope with its debt obligations. Times Interest Earned (TIE) is computed by picking a specific company’s earnings before interest and taxes (EBIT) and dividing the same by the total payable interest on contractual debt like bonds. TIE is usually cited as a ratio.


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Definition Sources


Definitions for Gearing are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 26th April, 2020 | 6 Views.