Capital Gearing: Definition, Meaning, How It Works, and Example

What Is Capital Gearing?

Capital gearing is a British term that refers to the amount of debt a company has relative to its equity. In the United States, capital gearing is known as "financial leverage."

Companies with high levels of capital gearing will have a larger amount of debt relative to their equity value. The gearing ratio is a measure of financial risk and expresses the amount of a company's debt in terms of its equity. A company with a gearing ratio of 2.0 would have twice as much debt as equity.

Understanding Capital Gearing

Capital gearing will differ between companies and industries. In industries requiring large capital investments, gearing ratios will be high. Lenders and investors pay close attention to the gearing ratio because a high ratio suggests that a company may not be able to meet its debt obligations if its business slows down.

Companies that are in cyclical industries and have high gearing ratios may, therefore, be viewed by investors as risky. In stable industries, however, a high gearing ratio may not present a concern. Utility companies, for example, require large capital investments, but they are monopolies and their rates are highly regulated. So, their revenues and income are highly stable.

Companies may at times increase their use of gearing. In the event of a leveraged buyout, the amount of capital gearing a company will employ will increase dramatically as the company takes on debt to finance the acquisition.

Leverage also increases when debt is cheap. This means that interest rates are low and banks have an appetite to supply financing. In 2005–2006, there was a huge increase in leverage due to cheap debt offerings, private equity deals boom, deregulation, and mortgage-backed securities growth.

Special Considerations

Capital gearing factors into a firm's creditworthiness. Lenders will often consider a company's gearing ratio when making decisions about extending credit, at what terms and interest rates, and whether it is collateralized or not. Often, lenders for debt structured as senior will disregard a firm's short-term obligations when calculating the gearing ratio, as senior lenders receive priority in the event of a business’s bankruptcy.

In cases where a lender would instead be considering an unsecured loan, the gearing ratio would incorporate information regarding the proportion of senior debt and preferred stock outstanding, which contain preferential repayment terms. This allows the lender to adjust the calculation to reflect the higher level of risk than would be present with a secured loan.

Example of Capital Gearing

As an example, in order to fund a new project, ABC, Inc. finds that it is unable to sell new shares to equity investors at a reasonable price. Instead, ABC looks to the debt market and secures a USD $15,000,000 loan with one year to maturity. At present, ABC, Inc. has $2,000,000 of equity value.

The gearing ratio would thus be 7.5x—[$15 million in total debt + equity, divided by $2 million in shareholders' equity]. ABC would certainly be considered a highly geared firm