What you need to know about gearing

Fsp Invest, 08 Nov. 2013

Tags: gearing, what is gearing, high gearing, what is high gearing, debt to equity, financial ratio, investing, company debt

When you look at the financial statements of a company, one thing you’ll come across is gearing. Gearing shows how much debt a company has compared with the equity in the company. But what should you look out for with gearing? Read on to uncover what you need to know about gearing…

A company’s gearing is its total borrowing divided by shareholder funds, Gareth Stokes explains in Fear, Greed and the Stock Market...

Gearing = ((Total borrowings/shareholder funds) x 100)

Let’s say Company ABC has gearing of 40%.That means its borrowings represent 40% of its shareholder funds. This is a reasonable level of gearing for a business.

You will typically find gearing on the balance sheet. The gearing ratio indicates the company’s debt as a proportion of its equity. Gearing shouldn’t be higher than 75%.

A gearing ratio greater than 100% indicates strain on the company’s finances.

What is high gearing?

This is when a company’s gearing is more than 75%. This happens when a company increases its borrowings relative to its shareholders’ funds. So a company is borrowing more money than it’s getting from its shareholders or making in profits.

A company creates shareholder funds when it issues shares or has profits to contribute to its reserves.

Holders of debt securities, like bonds, commercial paper or loan stock, rank higher than (and have priority over) shareholders. So increases in the level of company debt means the company channels more cash towards paying debts than paying dividends on shares.

High gearing is generally undesirable because the company’s finances might come under severe pressure if sales or profits fall. Companies with high gearing run higher risks and are under more pressure to perform.

Also highly geared companies tend to be very short-term in their outlook and decision-making. For example, they may cut back on research and development (R&D) to their detriment.

Shares in highly geared companies perform badly during recessions or periods of rising interest rates.

So there you have it, what you need to know about gearing.

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