What it means
Gearing, also called financial leverage, measures how much of a company's funding comes from debt rather than from shareholders. Degearing simply moves that mix back towards equity.
It is the opposite of gearing up, which is what companies do when they borrow to expand or to buy back shares. It matters because debt cuts both ways.
Interest must be paid whether or not the business has a good year, so a highly geared company has a much smaller margin for error when revenue dips. Reducing debt buys resilience and usually improves the terms available on whatever borrowing remains.
The common triggers are a covenant breach, a credit rating downgrade, an interest rate rise that makes floating-rate debt painful, or simply a board deciding the balance sheet has become stretched. Degearing also often follows an acquisition spree, once management wants to rebuild capacity for the next deal.
The main methods are repaying debt from operating cash, raising equity through a rights issue or share placing, selling non-core assets and applying the proceeds to loans, and cutting or suspending dividends so more profit is retained. Each carries a cost: equity issues dilute existing shareholders, asset sales remove future earnings, and dividend cuts upset income investors.
The trade-off is that leverage magnifies return on equity whenever the business earns more than it pays in interest. Degearing gives some of that up in exchange for lower risk, which is why heavily geared businesses usually degear gradually rather than all at once.
The right level depends on how predictable the cash flows are.
In practice
Real-world examples.
Example
A listed retailer has $200,000,000 of equity and $180,000,000 of net debt, a gearing ratio of 90%. It raises $60,000,000 in a rights issue and uses the cash to repay debt, so equity rises to $260,000,000 and debt falls to $120,000,000, cutting gearing to 46%.
Example
A family manufacturer suspends its $400,000 annual dividend for three years and applies the retained $1,200,000 to a term loan. Debt falls from $3,600,000 to $2,400,000 without any dilution of the family's shareholding.
Example
A privately owned services group sells a non-core division for $45,000,000 and repays $40,000,000 of acquisition debt. At an 8% interest rate that cuts the annual interest bill by $3,200,000, most of which flows straight to pre-tax profit.
Formula
Calculation
Gearing Ratio = Total Debt / Shareholders' Equity x 100
Debt to Total Capital = Total Debt / (Total Debt + Equity) x 100
A distribution business starts with $8,000,000 of debt at a 7% interest rate and $12,000,000 of equity.
Gearing: $8,000,000 / $12,000,000 = 66.7%
Debt to total capital: $8,000,000 / $20,000,000 = 40.0%
Annual interest: $8,000,000 x 7% = $560,000
It then sells a surplus warehouse at book value and uses $3,000,000 of the proceeds to repay debt, so equity is unchanged.
Gearing: $5,000,000 / $12,000,000 = 41.7%
Debt to total capital: $5,000,000 / $17,000,000 = 29.4%
Annual interest: $5,000,000 x 7% = $350,000
The interest saving is $560,000 - $350,000 = $210,000 a year, and the business now has far more headroom before a covenant bites.Case study
Seen in the real world.
Oakstead Logistics is a fictional company created to illustrate degearing. It borrowed heavily to buy two regional rivals, finishing with $56,000,000 of debt against $28,000,000 of equity, a gearing ratio of 200%, and leverage of 3.5 times its $16,000,000 of EBITDA.
When a major customer moved its contract elsewhere, EBITDA fell to $10,500,000 and leverage jumped to 5.3 times, breaching a covenant set at 4.0 times. The lenders waived the breach on condition that Oakstead presented a credible degearing plan within ninety days.
Over the next two years the owners injected $12,000,000 of new equity and the company sold $9,000,000 of surplus depots, cutting debt to $35,000,000. With EBITDA recovering to $12,500,000, leverage fell to 2.8 times and gearing to 87.5%, and the lenders reduced the margin on the remaining facility.
Watch out
Common mistakes.
- Assuming less debt is always better. Some leverage lowers the overall cost of capital because interest is tax deductible and debt is cheaper than equity.
- Measuring gearing on book equity alone. Market values can tell a very different story for listed companies, and lease obligations count as borrowing too.
- Degearing by selling the most profitable assets. Cutting debt while cutting earnings faster can leave the leverage ratio worse than before.
Questions
People also ask.
Is degearing the same as deleveraging?
Yes, the two terms mean the same thing, with deleveraging more common in North America and degearing more common in the UK.
Does degearing always help the share price?
Not necessarily, because it lowers risk but also lowers return on equity, so the market reaction depends on how stretched the balance sheet had become.
How fast should a company degear?
Usually over two to four years from operating cash flow, unless a covenant breach or a refinancing deadline forces a quicker fix through equity or asset sales.
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