Gearing refers to the level of debt that the company is having compared to its equity capital. It is usually expressed in percentage or ratio form. It helps to analyse the company’s leverage and how much of the operations of the company is being functioned or funded by lenders and how much is being funded by shareholders.
Gearing can also be measured by using debt equity ratio, equity ratio or debt service ratio. These ratios indicate the level of risk of the particular company. It can then be compared with its peers to determine whether the company is over leveraged or under leveraged. A gearing ratio of 80% indicates that the debt levels of the company are 80% of the equity of the company.
This ratio is considered by lenders when they are planning to extend credit. It helps them to understand whether the loan will be supported with enough collateral and also to make sure that the lender will be able to recover his dues even if the business fails. In cases of unsecured loans, the lenders may take into account the gearing of any preferred stockholders who may have been guaranteed payments.
A company having high degree of leverage will be having a high gearing ratio and will be more vulnerable in case of an economic downfall. This is because its cash flows will be affected to make interest payments which may be higher in such scenarios. On the other hand, in a good economic scenario, more leverage can be beneficial as the interest rates will be lower and the shareholders can expect a better return due to excess cash flows.