What it means
Every business is funded by some mix of debt and equity, and gearing describes that mix in a single figure. Debt is cheaper than equity and the interest is usually tax deductible, but it comes with fixed repayments that do not care whether trading was good this quarter.
There are two common ways to express the ratio, which is the main source of confusion. The debt to equity version divides total borrowings by shareholders' funds, so an answer above 100% means more debt than equity.
The debt to capital version divides borrowings by borrowings plus equity, so it always sits between 0% and 100%. What counts as high depends heavily on the industry.
A property company or utility with predictable, contracted cash flows can carry gearing that would be alarming in a fashion retailer or a consultancy, because the ability to service debt matters more than the ratio itself. Comparisons are only meaningful within a sector.
Managers use gearing when deciding how to fund growth. Adding debt keeps ownership concentrated and lifts returns to shareholders when the business earns more than the interest rate, while issuing equity dilutes existing owners but adds no fixed commitment.
Most boards set a target range and treat it as a boundary for major decisions. The nuance is that gearing is a snapshot from the balance sheet and says nothing about affordability.
A company can look modestly geared yet struggle to pay its interest if profits are thin, which is why gearing is nearly always read alongside interest cover and net debt to EBITDA. Leases and pension deficits should also be counted as debt-like obligations, since accounting standards now bring most leases onto the balance sheet.
In practice
Real-world examples.
Example
A logistics operator funds a new fleet with $8,000,000 of asset finance against $8,000,000 of equity, taking gearing to 100%. Its bank accepts this because the vehicles are readily saleable security and the haulage contracts run for five years.
Example
A design agency with almost no assets carries gearing of 15% because lenders will advance little against fee income. When the founders want to buy out a departing partner, they fund it from retained profits rather than debt.
Example
A listed housebuilder deliberately reduces gearing from 55% to 25% after a strong sales year, having learned from a previous downturn that high gearing forced it to sell land cheaply at the worst possible moment.
Think of it
“Financial gearing shows how much debt versus equity funds your company-your leverage level.
Formula
Calculation
Financial Gearing Ratio = (Total Debt / Shareholders' Equity) x 100
A commercial printing company has bank loans of $4,500,000, finance leases of $1,500,000 and shareholders' equity of $10,000,000.
Total debt = $4,500,000 + $1,500,000 = $6,000,000
Gearing = ($6,000,000 / $10,000,000) x 100 = 60%
On the alternative debt to capital basis, total capital = $6,000,000 + $10,000,000 = $16,000,000, so gearing = ($6,000,000 / $16,000,000) x 100 = 37.5%. Both describe the same company, which is why you must always state which version you are quoting. If the company then repaid $2,000,000 of loans from cash, debt would fall to $4,000,000 and gearing on the first basis would drop to 40%.Case study
Seen in the real world.
Pennington Foods is an illustrative, fictional company created to show how gearing decisions play out. It was a family-owned bakery supplying cafes, funded almost entirely by equity, with gearing of just 12% and a cautious board.
When a rival bakery came up for sale at $5,000,000, the family faced a choice. Funding it with debt would push gearing to roughly 70%, while issuing new shares to an outside investor would cut the family's holding from 100% to about 72%. The finance director modelled both, and the crucial figure was not the gearing percentage but interest cover, which would fall from 12 times to 3.4 times under the debt option.
The board chose a middle path, borrowing $3,000,000 and raising $2,000,000 from a minority investor, which left gearing near 45% and interest cover above 5 times. Two years later, when a key customer failed owing $600,000, that headroom is what allowed the fictional business to absorb the loss without breaching anything.
Watch out
Common mistakes.
- Quoting a gearing figure without saying whether it is debt to equity or debt to total capital, since the same company can honestly be described as 60% or 37.5% geared.
- Comparing gearing across different industries, when acceptable levels depend on how predictable and contracted the cash flows are.
- Excluding leases, invoice finance and pension deficits from debt, which understates the fixed obligations the business genuinely has to meet.
Questions
People also ask.
What is a healthy gearing ratio?
For many trading businesses a debt to equity figure below about 100% is considered comfortable, but asset-backed sectors routinely run higher and service businesses much lower.
Is high gearing always bad?
No, borrowing at 6% to fund activity earning 15% increases returns to shareholders, and the danger only appears when earnings fall short of the fixed interest bill.
How is gearing different from financial leverage?
Gearing is the specific balance sheet ratio, while financial leverage is the broader idea of using borrowed money to amplify returns, with gearing being the usual way of measuring it.
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