What it means
Gearing, called leverage in North American usage, describes the mix between funds that must be repaid with interest and funds provided by shareholders. The capital gearing ratio puts a number on that mix so it can be tracked and compared.
The most common presentation divides interest-bearing debt by total capital, which is debt plus equity, giving a percentage of the funding base that is borrowed. A closely related version divides debt by equity alone, and both are widely used, so it always pays to check which one a document means.
Gearing matters because debt is a fixed claim. Interest must be paid whether trading is strong or weak, so a highly geared business has less room to absorb a bad year before it breaches a loan covenant or runs short of cash.
The flip side is that debt is usually cheaper than equity and does not dilute ownership. A company earning 15% on capital that can borrow at 7% increases the return to shareholders every time it borrows, which is precisely why gearing is attractive up to a point.
Sensible gearing levels differ enormously by industry. A property investment company with long leases to strong tenants can carry gearing above 50% comfortably, while a fashion retailer with volatile sales and short leases would find the same level dangerous.
The nuance most often missed is that the ratio is a balance sheet snapshot and says nothing about affordability. Pairing it with an interest cover ratio, which compares operating profit with the annual interest bill, gives a far more complete picture of risk.
In practice
Real-world examples
Example 1
A hotel group with gearing of 62% approaches its bank for a refurbishment loan. The bank agrees only on condition that gearing does not exceed 65%, which effectively caps the borrowing and pushes the group toward a partial equity raise.
Example 2
A software company with gearing of 8% is criticised by an activist shareholder for being underborrowed. The argument is that cheap debt could fund buybacks and lift returns to shareholders without threatening solvency.
Example 3
A construction contractor lets gearing drift from 35% to 58% during a boom. When two large contracts are delayed, the interest bill still falls due, and the business has to sell plant at short notice to stay within its covenants.
Think of it
Capital gearing shows how much of your permanent capital is debt-the debt slice of long-term funding.
Formula
Calculation
Capital Gearing Ratio = Interest-Bearing Debt / (Interest-Bearing Debt + Shareholders' Equity)
Alternative form: Debt-to-Equity Gearing = Interest-Bearing Debt / Shareholders' Equity
Worked example. Aldergate Foods has long-term bank loans and bonds totalling $6,000,000 and shareholders' equity of $9,000,000.
Total capital = $6,000,000 + $9,000,000 = $15,000,000
Capital gearing ratio = $6,000,000 / $15,000,000 = 0.40, or 40%
On the alternative measure, debt to equity = $6,000,000 / $9,000,000 = 0.667, or about 67%.
Both describe the same balance sheet. Forty per cent of Aldergate's long-term funding is borrowed, and for every dollar shareholders have committed, lenders have committed roughly 67 cents.Case study
Seen in the real world
This illustrative case is entirely fictional. Kettleworth Packaging, an invented corrugated board manufacturer, financed a new plant almost entirely with debt because its owners did not want to dilute their shareholding. Gearing moved from 30% to 68% in eighteen months, and the annual interest bill rose from $420,000 to $1,340,000.
For two years the strategy worked, because the plant ran near capacity and operating profit comfortably covered interest more than four times over. Then a major customer moved its contract elsewhere, volumes fell by a quarter, and interest cover dropped to 1.3 times.
The board raised $4,000,000 of new equity at a price well below what the shares would have fetched two years earlier, bringing gearing back to about 45%. The illustrative lesson is that gearing decisions taken in good conditions are settled in bad ones, and the cost of fixing them is highest exactly when help is most needed.
Watch out
Common mistakes
- Comparing gearing ratios across industries without adjustment. A utility at 55% and a games studio at 55% carry entirely different levels of real risk.
- Quoting a gearing figure without saying which formula was used. Debt over total capital and debt over equity produce very different numbers from the same balance sheet.
- Ignoring off-balance-sheet or lease obligations. Long-term lease liabilities behave like debt, and leaving them out flatters the ratio.
Questions
People also ask
Is high gearing always bad?
No; predictable cash flows can support high gearing safely, and moderate borrowing often improves returns to shareholders through cheaper funding.
Which debts should be included?
Interest-bearing borrowings such as bank loans, bonds, overdrafts and lease liabilities, rather than trade payables owed to suppliers.
How does gearing differ from operating gearing?
Capital gearing concerns the mix of debt and equity funding, while operating gearing concerns the mix of fixed and variable costs in the profit and loss account.
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