Gearing Gearing, also called leverage, is the extent to which a company finances its operations with debt versus equity. It shows how much of a firm's capital comes from lenders compared with shareholders and is a core indicator of financial risk and creditworthiness. Why gearing matters
* Indicates financial risk: higher gearing means more fixed obligations (interest and principal) that must be met from cash flows.
* Affects credit decisions: lenders and rating agencies use gearing (and related adjustments for collateral and debt seniority) when assessing whether to extend credit and on what terms.
* Amplifies outcomes: in good times high gearing can boost returns to equity holders once debt costs are covered; in downturns it increases insolvency risk.
Key measures of gearing Common ratios used to quantify gearing include: Explore More Resources
* Debt-to-Equity (D/E) ratio
Formula: D/E = Total liabilities / Shareholders’ equity
Interprets how many dollars of debt exist for each dollar of equity.
* Equity (shareholders’ equity) ratio
Formula: Equity ratio = Shareholders’ equity / Total assets
Measures the portion of assets financed by owners rather than creditors. Explore More Resources
* Debt-Service Coverage Ratio (DSCR)
Formula: DSCR = Operating income available for debt service / Debt service (principal + interest)
Assesses the company’s ability to meet periodic debt obligations from operating cash flow.
Different stakeholders may adjust these calculations—for example, excluding certain short-term items, treating preferred stock differently, or accounting for secured vs unsecured debt—depending on the credit context. Explore More Resources
Example If a company takes a $10,000,000 loan and has $2,000,000 of shareholders’ equity, its D/E ratio is 5× (10,000,000 / 2,000,000). That indicates high gearing and greater financial leverage. Sector and peer context There is no universal “right” level of gearing. Acceptable leverage depends on: Explore More Resources
* Industry characteristics (stable, regulated businesses such as utilities often tolerate higher gearing; early-stage or highly competitive sectors like technology generally require lower gearing).
* Comparison with peer companies and common lending practices in the sector.
* The company’s cash-flow stability and collateral support.
For example, a gearing ratio of 70% might be manageable for a regulated utility but excessive for a fast-changing tech firm. Lender perspective and special considerations Lenders evaluate gearing alongside other factors: Explore More Resources
* Collateral and loan seniority: secured or senior lenders have priority in bankruptcy, which affects perceived risk and how gearing is interpreted.
* Presence of preferred stock or other creditor-like claims, which can influence the effective capital cushion.
* Adjustments for short-term obligations or off-balance-sheet items when assessing true debt exposure.
Unsecured lenders typically demand a more conservative view of gearing because they lack repayment priority and collateral. Gearing versus risk
* Upside: When earnings exceed borrowing costs, leverage amplifies returns to equity holders.
* Downside: Leverage magnifies losses and increases the chance of default when cash flows decline, making highly geared firms more vulnerable in downturns.
Takeaways
* Gearing measures financial leverage: how much debt funds a company relative to equity.
* D/E ratio, equity ratio, and DSCR are common measures.
* Appropriate gearing varies by industry, cash-flow stability, and peer norms.
* Lenders adjust gearing assessments for collateral, seniority, and the nature of claims.
* High gearing can boost returns in good times but increases insolvency risk in bad times.