Gearing (in finance) refers to the proportion of a company’s business assets that are funded by debt relative to that financed by equity.
A higher level of borrowing, all else equal, represents a risk to the equity holders as interest and principal repayments are not discretionary in the same that dividends are.
As a general rule, firms with less than 30% gearing are said to be low risk, whilst those above 60% are described as higher risk, though there are caveats as we shall see below.
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Also known as Leverage, it is most commonly measured by ratios such as the Debt-to-Equity ratio.
Alongside other indicators it can help a lender decide if the company concerned is a good credit risk.
In conjunction with data concerning the presence of more senior creditors, a lending institution would be better able to assess the level of risk involved in any proposed loan.
Debt in itself is not necessarily a bad thing, provided it is longer term in nature and at acceptable price and some firms (highly cyclical firms for example), may not be able to finance their operations via shareholder equity alone.
Clearly, the more excessive the gearing, the bigger the risk for share and bond holders in the event of recession etc.
For investors, what constitutes a sensible level of gearing- depends on the industry concerned and its ability to grow cash flow etc.
A non-cyclical business (e.g. a power company) will be able to support higher levels of gearing than will one in a more competitive field of business (e.g. a retail shopping firm).
For this reason comparisons across industries are less meaningful that those done within industries/sectors etc.
The long-term capital structure of a business is at the discretion of management (and to a lesser extent, shareholders) and thus can be altered should circumstances (or market pressures) require it.
Issuing more shares/repaying or converting loans into equity and paying out lower dividends will tend to reduce gearing, whilst higher dividends, introducing share buybacks or issuance of preference shares or loans can be expected to raise gearing