Have you ever wondered why some companies seem to be walking a financial tightrope while others appear more stable? The answer might lie in their “gearing” – a concept that’s crucial to understand if your looking at investing or analyzing businesses Today, I’m gonna break down what a highly geared company actually is, why it matters, and how it might affect investment decisions
The Basics of Gearing: Debt vs. Equity
Gearing also known as leverage, refers to the extent to which a company is financed with debt rather than equity. In simpler terms it tells us how much a business relies on borrowed money versus shareholder investments to fund its operations.
When we talk about a “highly geared” company, we’re describing a business that has a large amount of debt compared to its share capital. In American business language, this is often called “highly leveraged” instead
The fundamental question gearing answers is: Who’s funding the company – lenders or shareholders?
How to Measure Gearing
There are several ways to calculate and measure a company’s gearing level:
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Debt-to-Equity (D/E) Ratio: This is the most common measure, calculated by dividing total liabilities by shareholders’ equity.
D/E Ratio = Total Liabilities ÷ Shareholders’ Equity
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Shareholders’ Equity Ratio: Shows what proportion of total assets is financed by shareholders.
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Debt-Service Coverage Ratio (DSCR): Indicates a company’s ability to service its debt using its operating income.
Example Calculation
Let’s look at a simple example:
XYZ Corp needs $10,000,000 for expansion but can’t sell additional shares at a good price. Instead, they get a short-term loan for the full amount. They currently have $2,000,000 in equity.
Their D/E ratio would be:
$10,000,000 (debt) ÷ $2,000,000 (equity) = 5
With a D/E ratio of 5 (or 500%), XYZ Corp would definitely be considered highly geared!
What Makes a Company “Highly Geared”?
There’s no universal threshold that defines “high gearing,” as appropriate levels vary significantly by industry. However, here are some general guidelines:
- A gearing ratio of 70% means a company’s debt levels are 70% of its equity
- For a utility company, 70% might be perfectly manageable
- For a technology company facing rapid market changes and intense competition, 70% might be excessive
The context matters enormously. Companies in stable industries with predictable cash flows (like utilities) can typically handle higher gearing than businesses in volatile sectors.
The Double-Edged Sword: Benefits and Risks
Potential Benefits of High Gearing
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Amplified Returns: A highly geared company can be extremely profitable when things go well. If it generates returns higher than its cost of borrowing, the excess benefits flow to shareholders.
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Tax Advantages: In many jurisdictions, interest payments are tax-deductible, whereas dividend payments to shareholders aren’t.
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Maintaining Control: Using debt instead of issuing more shares means existing shareholders maintain their control percentages.
The Significant Risks
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Vulnerability to Economic Downturns: When the economy slows, highly geared companies are more vulnerable because they must continue making interest payments despite potentially declining cash flows.
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Financial Distress: If a company struggles to meet its debt obligations, it faces potential bankruptcy.
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Limited Future Borrowing: High gearing can limit a company’s ability to borrow more in the future, potentially restricting growth opportunities.
As the Cambridge Dictionary definition notes: “Companies with high debts are ‘highly geared’, and face financial difficulties if their profits fall or interest rates rise.”
Real-World Examples and Implications
High gearing isn’t inherently good or bad – it depends on the circumstances. Here are some real-world contexts where gearing matters:
Industry Variations
Different industries have different “normal” gearing levels:
- Capital-Intensive Industries (like manufacturing or utilities): Typically have higher gearing due to substantial infrastructure investments
- Service-Based Businesses: Often have lower gearing as they require less physical capital
Practical Example
According to examples from the Cambridge Dictionary, the motor industry is typically highly geared, particularly its export divisions, which can be affected by increases in unit costs. This makes sense given the massive capital expenditure necessary for efficient and automated mass production.
Gearing and Creditworthiness
Gearing significantly impacts a company’s ability to secure additional financing. Lenders carefully examine gearing ratios when deciding whether to extend credit.
When assessing a highly geared company, lenders might:
- Request collateral to secure the loan
- Consider their position in the lender hierarchy (senior vs junior)
- Charge higher interest rates to compensate for increased risk
- Impose strict covenants to protect their investment
As noted in the Investopedia article, “senior lenders might choose to remove short-term debt obligations when calculating the gearing ratio, as senior lenders receive priority in the event of a business’s bankruptcy.”
How Investors Should Approach Highly Geared Companies
If your considering investing in a highly geared company, here’s what I recommend:
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Compare to Industry Peers: Is the company’s gearing typical for its sector?
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Examine Cash Flow Stability: Stable, predictable cash flows make high gearing less risky.
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Consider the Economic Environment: Rising interest rates can spell trouble for highly geared companies.
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Assess Management Quality: Good management can navigate the challenges of high gearing more successfully.
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Look at Historical Performance: How has the company handled its debt in past economic downturns?
Examples in Different Contexts
Personal Finance Parallel
Individuals can also be “highly geared” – the Cambridge Dictionary notes that a highly geared person has “borrowed a large amount of money compared to their income or the amount of capital they already have.” The dictionary specifically mentions that “US consumers are even more highly geared than UK ones.”
Public Sector Examples
The concept extends beyond private companies. The Cambridge Dictionary examples mention that “public sector finances are highly geared to changes in the level of the economy,” and that “highly geared local authorities” can be particularly affected by certain policy changes.
Signs That a Company Might Be Too Highly Geared
How can you tell if a company’s gearing has become problematic? Watch for these warning signs:
- Declining interest coverage ratios
- Rising borrowing costs
- Difficulty refinancing existing debt
- Selling core assets to service debt
- Cutting dividends to conserve cash
- Renegotiating debt terms with lenders
The Ideal Approach to Gearing
So what’s the optimal gearing strategy? There isn’t a one-size-fits-all answer, but most financial experts suggest a balanced approach:
- Match Financing to Assets: Long-term assets should be financed with long-term capital
- Maintain Flexibility: Keep some borrowing capacity in reserve for opportunities
- Stress Test: Model how the company would perform in adverse conditions
- Regular Review: Gearing strategies should evolve with market conditions
Case Study: The Danger of Excessive Gearing
The global financial crisis of 2008 provided a stark lesson about the dangers of excessive gearing. Many banks and financial institutions had leveraged themselves to extraordinary levels, some with debt-to-equity ratios exceeding 30:1.
When asset values began to fall, these institutions quickly became insolvent because even small percentage declines in asset values wiped out their equity bases. This cascaded through the financial system, leading to the worst economic crisis since the Great Depression.
Summary: The Key Takeaways About Highly Geared Companies
To wrap things up, here are the essential points to remember about highly geared companies:
- A highly geared company has a large amount of debt compared to its share capital
- Gearing is measured through ratios like debt-to-equity (D/E)
- High gearing amplifies both potential returns and risks
- Appropriate gearing levels vary significantly by industry
- Economic downturns are particularly dangerous for highly geared companies
- Lenders and investors should carefully assess gearing when making decisions
Final Thoughts
Understanding gearing is crucial for anyone involved in business analysis, investing, or corporate finance. While high gearing can supercharge returns in good times, it can also accelerate decline during downturns.
When I’m analyzing companies, I always look at gearing in context – comparing it to industry peers, examining the stability of cash flows, and considering the broader economic environment. There’s no magic number that defines “too much” gearing – it’s always relative to the specific circumstances of the company and its operating environment.
Whether your an investor, business owner, or simply interested in financial literacy, recognizing the significance of gearing will help you make more informed decisions and better understand the risk profile of different businesses.
Remember: it’s not about avoiding debt altogether, but rather ensuring that the level of debt is appropriate for the company’s specific situation and strategy. After all, the right amount of gearing can be a powerful tool for growth when used wisely.
Companies and Financial Gearing
There are several instances when a company may engage in financial gearing to strengthen its capital structure, including the following:
When sourcing for new capital to support the company’s operations, a business enjoys the option of choosing between debt and equity capital. Most owners prefer debt capital over equity, since issuing more stocks will dilute their ownership stake in the company. A profitable company can use borrowed funds to generate more revenues and use the returns to service the debt, without affecting the ownership structure.
A company that mainly relies on equity capital to finance operations throughout the year may experience cash shortfalls that affect the normal operations of the company. The best remedy for such a situation is to seek additional cash from lenders to finance the operations. Debt capital is readily available from financial institutions and investors as long as the company appears financially sound.
A company may require a large amount of capital to finance major investments such as acquiring a competitor firm or purchasing the essential assets of a firm that is exiting the market. Such investments require urgent action, and shareholders may not be in a position to raise the required capital due to the time limitations. If the business is on good terms with its creditors, it may obtain large amounts of capital quickly as long as it meets the loan requirements.
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Gearing Ratio and Risk
The degree of gearing, whether low or high, reveals the level of financial risk that a company faces. A highly geared company is more susceptible to economic downturns and faces a greater risk of default and financial failure. This means that with the limited cash flows that the company is getting, it must meet its operational costs and make debt payments. A company may frequently experience a shortfall in cash flows and fail to pay equity shareholders and creditors.
A low gearing ratio may not necessarily mean that the business’ capital structure is healthy. Capital intensive firms and firms that are highly cyclical may not be able to finance their operations from shareholder equity only. At some point, they will need to obtain financing from other sources in order to continue operations. Without debt financing, the business may be unable to fund most of its operations and pay internal costs.
A business that does not use debt capital misses out on cheaper forms of capital, increased profits, and more investor interest. For example, companies in the agricultural industry are affected by seasonal demands for their products. They, therefore, often need to borrow funds on at least a short-term basis.
Lenders use gearing ratios to determine whether to extend credit or not. They are in the business of generating interest income by lending money. Lenders consider gearing ratios to help determine the borrower’s ability to repay a loan.
For example, a startup company with a high gearing ratio faces a higher risk of failing. Most lenders would prefer to stay away from such clients. However, monopolistic companies like utility and energy firms can often operate safely with high debt levels, due to their strong industry position.
Investors use gearing ratios to determine whether a business is a viable investment. Companies with a strong balance sheet and low gearing ratios more easily attract investors. Investors may view companies with a high gearing ratio as too risky.
A highly geared firm is already paying high amounts of interest to its lenders and new investors may be reluctant to invest their money, since the business may not be able to pay back the money.
Gearing ratios are used as a comparison tool to determine the performance of one company vs another company in the same industry. When used as a standalone calculation, a company’s gearing ratio may not mean a lot. Comparing gearing ratios of similar companies in the same industry provides more meaningful data.
For example, a company with a gearing ratio of 60% may be perceived as high risk. But if its main competitor shows a 70% gearing ratio, against an industry average of 80%, the company with a 60% ratio is, by comparison, performing optimally.
Below is a screenshot from CFI’s Leveraged Buyout (LBO) Modeling course, in which a private equity firm uses significant leverage to enhance the internal rate of return (IRR) for equity investors.
Highly-geared & Lowly-geared Company: Formulas & Examples
FAQ
What does it mean when a company is highly geared?
Meaning of highly geared in English
used to describe a company that has a large amount of debt compared to its share capital, (= money in shares) or the structure of such a company’s capital: Companies with high debts are ‘highly geared’, and face financial difficulties if their profits fall or interest rates rise.
Is high gearing good or bad?
Whether you measure it as a percentage or a fraction, a lower gearing ratio is usually better than a higher one. Put simply, the higher a business’s gearing ratio, the more vulnerable it is and the higher the risk it represents to lenders or investors.
What does it mean when a company is geared?
In investment analysis, a highly geared company is one where small changes in sales produce big swings in profits. Gearing consists of financial and operational gearing. Leverage is the corresponding US term.
What is considered a highly leveraged company?
Leverage usually describes the amount of a company’s debt relative to the equity in its capital structure. A highly leveraged company (sometimes called a highly levered company) is considered to have a large amount of debt compared to its equity.