Gearing

Term of the Day - 5 February 2024

Today’s Term is “Gearing”.

Gearing, in the context of accounting and finance, refers to the proportion of a company's capital structure that is financed by debt compared to equity. It indicates the extent to which a company relies on debt financing to fund its operations and investments.

Gearing is typically expressed as a ratio, known as the gearing ratio or leverage ratio, which compares the company's debt to its equity. The formula for calculating the gearing ratio is:

Gearing Ratio = (Total Debt / Total Equity) x 100%

A high gearing ratio implies that a significant portion of the company's capital comes from debt, while a low gearing ratio suggests a greater reliance on equity financing.

Gearing can have both advantages and disadvantages. On the one hand, debt financing can provide tax advantages due to the deductibility of interest expenses and can enable companies to leverage their investments to potentially generate higher returns. On the other hand, high levels of gearing can increase financial risk, as companies may struggle to meet debt obligations, especially during economic downturns or periods of financial distress.

Monitoring gearing levels is important for investors, creditors, and management to assess the financial health and risk profile of a company, helping them make informed decisions about investment, lending, and strategic planning.