GEARING
11 May 2016 By PDSNET(1) The relationship of a company's borrowings or debt to ordinary shareholders' funds. The American term for gearing is "leverage". A company can obtain the finance it needs to conduct its operations from two sources: by the issuing of its ordinary shares and by borrowing from third parties like banks. The ratio of the one to the other determines the company's gearing. This ratio is also sometimes called the debt/equity ratio. We say that a company is "highly geared" if the borrowings from external sources exceed the shareholders' capital by an excessive amount. A company is "fully geared" if no further credit can be obtained. With a Real estate Investment Trust (REIT) where the value of the company's debt is more than 40% of the value of its properties, it is considered highly geared. and hence more risky. Highly geared companies reduce debt by raising additional capital through a rights issue or other issue, selling off assets, retaining profits and reducing expenses. An over-geared company is at risk, especially if interest rates rise. In a period of rising interest rates, an over-geared company can be caught between falling sales and an increasing interest rate bill. During COVID-19 from March 2020 until the end of 2021, many over-geared companies were forced to sell assets to reduce gearing. Some had to undertake rights issues despite the fact that their shares were trading well below their net asset value (NAV).
(2) The term gearing or leverage when applied to an investment refers to the fact that the investor is only required to put down a small fraction of the investment which he/she commands. For example, most derivative contracts (futures and options etc.) only require the investor to put down about 10% of the size of the investment. Currency contracts typically only require 1% of the size of the contract to be invested. This means that a 1% rise in the currency will double the investors money while a 1% fall will wipe him out completely. In investment high gearing or leverage is associated with high levels of risk.
Share this glossary term: