What it means
Gearing is the British term for what is often called financial leverage. It compares interest-bearing debt, such as bank loans, overdrafts and finance leases, with shareholders' equity, meaning the money owners have put in plus the profits kept in the business.
The ratio matters because debt and equity behave very differently when trading gets difficult. Interest and repayments must be paid on schedule whatever happens to sales, while dividends to shareholders can be reduced or skipped, so a highly geared company has far less room to absorb a bad year.
In practice the number turns up in three places. Loan agreements often set a maximum gearing level as a covenant, credit assessors use it to price the interest rate offered, and boards use it to decide whether the next expansion should be funded by borrowing or by issuing shares.
There are several accepted versions of the calculation, so always ask which one someone means. The most common is debt divided by equity, but many analysts prefer debt divided by total capital, which never exceeds 100% and is easier to compare, and net gearing subtracts surplus cash from debt first.
What counts as high depends entirely on the industry. Utilities, property companies and infrastructure operators run comfortably at high gearing because their cash flows are predictable and asset-backed, while a young software business with volatile revenue would be considered reckless at the same level.
In practice
Real-world examples.
Example
A packaging manufacturer has a loan covenant capping gearing at 80%. It wants to borrow another $1,000,000 for a new line, which would take debt to $4,000,000 against equity of $5,000,000, or 80% exactly. The finance director decides to fund half the machine from retained profit instead, keeping headroom under the covenant.
Example
A family-owned hotel group runs at 150% gearing because its properties are valuable and its occupancy is steady. When a downturn cuts room revenue by a fifth, interest payments stay fixed and the group has to renegotiate its repayment schedule with the bank.
Example
A subscription software business has no borrowings at all, so its gearing ratio is 0%. Its board treats this as a deliberate choice: with revenue still unpredictable, it would rather dilute ownership by issuing shares than commit to fixed repayments.
Formula
Calculation
Gearing Ratio = Total Debt / Shareholders' Equity x 100
A regional packaging manufacturer has a bank term loan of $2,400,000 and finance leases of $600,000, giving total debt of $2,400,000 + $600,000 = $3,000,000. Shareholders' equity on the balance sheet is $5,000,000. Gearing = $3,000,000 / $5,000,000 x 100 = 60%. Using the debt-to-capital version instead: $3,000,000 / ($3,000,000 + $5,000,000) = $3,000,000 / $8,000,000 = 37.5%. Both numbers describe the same balance sheet, which is exactly why you must state which definition you are quoting.Case study
Seen in the real world.
Harrowgate Bakeries is an illustrative, entirely fictional regional bakery chain used here to show gearing in action. To fund eleven new shops, the founders borrowed $6,000,000 against equity of $3,000,000, lifting gearing from 40% to 200% in a single year.
For two years the strategy looked clever, because the new shops earned more than the interest cost and profit per share rose sharply. Then a sustained jump in flour and energy prices squeezed margins, and the fixed interest bill of roughly $480,000 a year swallowed most of what was left.
The board raised $2,000,000 from a new investor, repaid part of the loan and brought gearing back to about 89%. The illustrative lesson is not that debt was wrong, but that the founders had geared the business for good weather only.
Watch out
Common mistakes.
- Treating a high gearing ratio as automatically bad. A steady, asset-rich business can carry gearing that would sink a volatile one, so the number only means something against an industry benchmark.
- Including trade payables and accruals in debt. Gearing normally counts interest-bearing borrowings only, and quietly adding supplier balances inflates the ratio and breaks comparability.
- Forgetting that equity moves too. A large write-down of goodwill reduces equity without changing debt at all, so gearing can jump sharply even though the company has not borrowed a penny more.
Questions
People also ask.
Is gearing the same thing as leverage?
Effectively yes, gearing is the term used more often in the UK and Commonwealth markets while leverage is the usual North American word for the same idea.
Should operating leases be counted as debt?
Under current accounting most leases already sit on the balance sheet as lease liabilities, and lenders generally treat them as debt for gearing purposes.
What gearing level do banks usually want to see?
For an ordinary trading company many lenders are comfortable below roughly 100% debt to equity and start asking harder questions above it, though property and infrastructure lending works to far higher limits.
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