Reviewed by Oct 05, 2020| Updated on
Gearing is the ratio of a company's debt to equity. It denotes the extent to which a company's operations are funded by lenders in comparison with the shareholders. Gearing measure the company's financial leverage. For example, if a company's equity to debt ratio is high, the business is said to be highly-reared or highly-leveraged.
Company ABC wants to fund its expansion, but cannot sell additional shares to investors at a reasonable price. Instead, the company takes a short-term loan of Rs.1 crore. If Company ABC has equity worth Rs.20 lakh, the debt-to-equity ratio is 5, i.e. Rs.1 crore divided by Rs.20 lakh. Company ABC is highly-geared based on the given data.
A number of ratios determine gearing, such as debt-to-equity ratio, debt-service coverage ratio, and shareholders' equity ratio. These ratios indicate the risk level associated with a business. The ideal gearing for a company may vary depending on the sector and degree of leverage of its peers.
A company's creditworthiness is determined based on the gearing or leverage of the company. Lenders consider the gearing ratio to make informed decisions on lending credit to a company. Other factors that help make this decision are the availability of collateral and the seniority of the lender. Senior lenders ignore short-term debt obligations while calculating gearing ratio.
In the case of a lender offering an unsecured loan, the gearing ratio will consider information such as the preferred stockholders who guarantee certain payments. The calculations, in this case, will take into account the higher risk level, unlike the case of a secured loan.