Gearing
1.
Financial gearing measures the relative amount of debt in a firm's capital structure.
Gearing is sometimes also known as leverage.
Gearing and leverage ratios can be calculated in several different ways, so consistency of approach is important.
Two essential bases to define are:
i. The use of book or market values.
ii. The use of Debt divided by Equity (D/E) or of Debt divided by Debt plus Equity = D / (D+E).
Example 1: Calculation of gearing
Gearing
Assume the values of debt and equity are equal, say USD 1m each.
D/E = 1/1 = 100%.
This is usually known as 'gearing'.
Example 2: Calculation of leverage
Leverage
Using the other calculation with the same inputs (D = 1 and E = 1):
D / (D+E) = 1/2 = 50%.
This is usually known as 'leverage'.
Adjustments to D and E figures
With respect to the Debt figure, practice varies in including or excluding certain items such as cash, short term borrowings, leases, pensions and other provisions.
Practitioners may also adjust the Equity figure, for example to exclude intangible assets.
Bank supervision
In the banking context, the calculation of the regulatory Leverage Ratio is strictly specified, following Basel III.
2.
Operational gearing relates to the operating costs of a business, and measures the relative proportions of fixed and variable operating costs.
3.
'Gearing up' refers to increasing the levels of financial or operation gearing - or both - within an organisation.
The intention of gearing up is to improve expected net results.
A consequence of gearing up is normally to increase risk.
Many financial disasters have been a consequence of gearing up (or leveraging) excessively in this way in earlier periods.
See also
- Balance sheet ratio
- Basel III
- Debt equity ratio
- Debt to equity ratio
- Geared beta
- Intangible assets
- Interest cover
- Leverage
- Leverage Ratio
- Leveraged
- Leveraged takeover
- Levered
- MCT
- Off balance sheet finance
- Tax shield
- Ungeared
- Ungeared cash flow
Other links
Masterclass: Measuring financial risk, The Treasurer, July 2012
