What it means
The ratio compares long-term debt with the total of long-term debt plus shareholders' equity, and it is normally quoted as a percentage. Some analysts prefer the debt-to-equity version, which divides debt by equity alone and therefore produces a larger-looking number.
Both describe the same underlying position, so always check which convention is in use. Gearing matters because debt comes with obligations that equity does not.
Interest must be paid whether the business had a good year or a bad one, and the principal must be repaid on schedule, so a highly geared business has far less room to absorb a downturn. The flip side is that gearing amplifies returns to shareholders when trading is good.
If borrowed money earns more than it costs, the surplus belongs entirely to the equity holders, which is why the concept is also called financial leverage. The same mechanism works just as powerfully in reverse.
What counts as high depends heavily on the industry. Utilities and property companies with predictable cash flows and hard security routinely run at 50% to 70%, while a software business with no tangible assets and volatile revenue might be considered stretched above 25%.
Comparisons only mean something within a sector. Gearing is usually read alongside interest cover, which measures how many times operating profit covers the interest bill.
A company can look moderately geared on the balance sheet and still be uncomfortable if profits only cover interest one and a half times, since a small dip in trading would leave it unable to pay.
In practice
Real-world examples.
Example
A property investment company runs at 65% gearing against long-leased commercial buildings. Its lender is relaxed because rent is contracted for 12 years and the loans are secured on the properties themselves.
Example
A recruitment agency with no tangible assets keeps gearing at 10% deliberately. Its fee income swings sharply with the hiring cycle, and the founders would rather give up amplified returns than risk fixed repayments in a slow year.
Example
A brewery is bought in a leveraged transaction that lifts gearing from 20% to 72%. Trading holds up and equity returns are excellent for three years, but a poor summer cuts profit by 30% and the company has to renegotiate covenants.
Formula
Calculation
Capital Gearing = Long-Term Debt / (Long-Term Debt + Shareholders' Equity) x 100
A packaging manufacturer has $4,000,000 of long-term bank debt and $6,000,000 of shareholders' equity.
Total capital employed: $4,000,000 + $6,000,000 = $10,000,000
Capital gearing: $4,000,000 / $10,000,000 = 0.40, or 40%
On the alternative debt-to-equity basis:
Debt to equity: $4,000,000 / $6,000,000 = 0.667, or about 67%
Now check the affordability. The debt carries interest at 6% and the company's operating profit is $900,000.
Annual interest: $4,000,000 x 6% = $240,000
Interest cover: $900,000 / $240,000 = 3.75 times
At 40% gearing with interest covered 3.75 times, this is a comfortable position for a manufacturer. Profits could fall by roughly two thirds before the interest bill became unaffordable.Case study
Seen in the real world.
This is an illustrative and fictional scenario. Thornbury Engineering financed a $9m acquisition almost entirely with debt, taking gearing from 28% to 66% in a single quarter. The board's reasoning was that borrowing was cheap and the acquired order book was full.
For two years the arithmetic looked excellent. The acquired business earned around 14% on the money invested while the debt cost 6%, and the surplus flowed straight to shareholders, lifting return on equity from 11% to 19%. The board pointed to the numbers as proof that the strategy had been right.
Then a major customer moved production overseas and group operating profit fell by 35%. Interest cover dropped from 3.1 times to 2.0, the bank tightened covenants, and Thornbury had to sell a profitable division to bring gearing back to 45%. The illustrative lesson is that gearing does not create returns; it enlarges whatever the business was going to deliver anyway, in both directions.
Watch out
Common mistakes.
- Assuming low gearing is always safer for shareholders. Very low gearing can mean the business is leaving cheap funding unused and earning less on equity than it comfortably could.
- Comparing gearing across different industries. A 60% figure is unremarkable for a property company and alarming for an advertising agency, so the sector context is essential.
- Excluding lease obligations from the calculation. Long-term leases commit the business to fixed payments in the same way debt does, and modern accounting standards put most of them on the balance sheet for exactly that reason.
Questions
People also ask.
Is capital gearing the same as financial leverage?
Effectively yes; gearing is the British term and leverage the American one, both describing the use of debt to amplify returns to equity.
What gearing level should trigger concern?
There is no universal figure, but many lenders start asking harder questions above 50%, and interest cover below 2 times is usually a stronger warning signal than the ratio itself.
Should short-term debt be included?
The classic ratio uses long-term debt only, though many analysts include all interest-bearing borrowing net of cash to get a fuller picture of the commitment.
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