What it means
Every business is funded by some mix of debt and equity, and gearing is the ratio that describes that mix. The most common version divides borrowings by shareholders' equity, so a gearing ratio of 75% means the business has $0.75 of debt for every $1.00 of owners' money.
The effect of gearing is amplification. Because interest is a fixed cost, a highly geared business converts a small movement in operating profit into a much larger movement in the profit available to shareholders, in both directions.
That is why lenders and investors watch it so closely. Debt is cheaper than equity and the interest is usually tax deductible, but it must be serviced in bad years as well as good, and a company that cannot meet its interest bill is in trouble regardless of how promising it looks.
There is no universally correct level, because the right gearing depends on how predictable the cash flows are. A water utility with contracted revenue can carry gearing that would be reckless for an advertising agency whose income swings with the economy.
Two refinements are worth knowing. Net gearing deducts cash from debt, which matters for businesses sitting on large balances, and interest cover, calculated as operating profit divided by interest, tests affordability rather than the size of the balance sheet.
Gearing is also where loan covenants bite. Lenders typically set a maximum gearing ratio and a minimum interest cover, tested quarterly, and breaching either can trigger higher margins, extra reporting or in the worst case an immediate demand for repayment, which is why finance teams forecast these ratios rather than simply reporting them after the event.
In practice
Real-world examples
Example 1
A property investment company runs at 70% gearing because rental income is contracted and predictable. Its lender sets a covenant requiring gearing to stay below 75%, tested every quarter.
Example 2
A design agency deliberately keeps gearing near zero, funding growth from retained profits. Fee income can fall 30% in a downturn, and fixed interest payments would be dangerous against that volatility.
Example 3
A private equity buyer acquires a manufacturer using $60,000,000 of debt and $20,000,000 of equity, giving gearing of 300%. The structure boosts the potential return on the equity but leaves almost no room for a trading shortfall.
Think of it
Think of gearing like using a credit card to buy something big. If you can pay it off easily with your income, it's manageable. But if you're using the card for everything and can't keep up with payments, it becomes risky.
Formula
Calculation
Gearing ratio = Total debt / Shareholders' equity, expressed as a percentage. A common alternative is Debt / (Debt + Equity), and Interest cover = Operating profit / Interest expense.
A regional bakery group has bank loans of $4,500,000, shareholders' equity of $6,000,000 and cash of $500,000. Operating profit is $1,800,000 and the loans carry interest at 8%.
Gearing ratio = $4,500,000 / $6,000,000 = 0.75, or 75%.
Net debt = $4,500,000 - $500,000 = $4,000,000, so net gearing = $4,000,000 / $6,000,000 = 66.7%.
On the debt to total capital basis, gearing = $4,500,000 / ($4,500,000 + $6,000,000) = $4,500,000 / $10,500,000 = 42.9%.
Interest expense = $4,500,000 x 0.08 = $360,000, so interest cover = $1,800,000 / $360,000 = 5.0 times. If operating profit fell by a third to $1,200,000, interest cover would drop to $1,200,000 / $360,000 = 3.3 times, which is where most lenders start asking questions.Case study
Seen in the real world
Ardenne Foods is an illustrative, fictional chilled ready meals producer that borrowed $12,000,000 against $6,000,000 of equity to buy a second factory, taking gearing to 200%. With operating profit of $2,400,000 and interest at 7%, interest cover was $2,400,000 / $840,000 = 2.9 times, which the bank accepted on the strength of a supermarket contract.
Eighteen months later the supermarket moved a large own-label line to a rival supplier and Ardenne's operating profit fell to $1,000,000. Interest cover dropped to $1,000,000 / $840,000 = 1.2 times, breaching a covenant set at 2.0 times, and the bank imposed a higher margin and monthly reporting.
The illustrative point is that gearing did not cause the lost contract, it simply removed the room to absorb it. Ardenne eventually raised $4,000,000 of new equity to cut debt to $8,000,000, bringing gearing back to 80% on the enlarged equity base of $10,000,000.
Watch out
Common mistakes
- Assuming low gearing is always better. A business with no debt at all may be under-using cheap funding and delivering a lower return on equity than it could.
- Comparing gearing ratios across different industries. Acceptable levels vary enormously with the predictability of cash flow, so a utility and a software start-up are not comparable.
- Looking at the ratio without checking affordability. A modest gearing ratio can still be dangerous if interest cover is thin, and interest cover is the measure that predicts distress.
Questions
People also ask
What counts as debt in the gearing calculation?
Interest-bearing borrowings such as bank loans, bonds, overdrafts and finance leases, though analysts differ on whether to include all lease obligations.
What is a typical gearing ratio?
Many established businesses sit somewhere between 25% and 100% on a debt to equity basis, but the sensible range depends entirely on the stability of earnings.
Is gearing the same as leverage?
Yes in the financial sense, since gearing is the British term and leverage the American one for the same relationship between debt and equity funding.