Gearing

Corporate financial accounting is not one of my favourite subjects, but once in a while I come across a topic that piques my interest. In this case, it is gearing. Gears are circular machine parts with teeth and are often paired up to form a mesh. Gears in motion rotate and fit into each other; often, one is bigger than the other. Gears, no matter how small, are an important feature in any machine that features them. They are the heart of the machine, and if the gears do not work, the machine does not work well. Physics adopted gears in mechanical productions, and over the years we have seen gears and made use of them in our everyday lives, the most popular being driving a vehicle. Without a gear in place or in the case of gear failure, the vehicle will not move.

Gearing in accounting seems to have been borrowed from physics. In simple terms, gearing is the ratio of a company’s liability (debt) to its owner’s equity (funding by the owner(s)). Even in this instance, gearing is an important component of a company’s operation. A business requires capital to set up, and that can be done in different ways: by investing personal funds, getting other people to invest as shareholders, getting a loan, or a mix of the three. Like a gear wheel, you will oftentimes notice a small gear controlling the movement of the big gear and vice versa. The same applies to accounting gearing. The ratio of liability to equity can be greater, lesser, or equal.

For most businesses, a gearing of 25%–50% is considered normal and moderately geared. The business is considered low-risk if the gearing is less than 25%. If the gearing is higher than 50%, the business is considered to be highly geared, and companies that fall under this category are said to be high risk. However, this is not set in stone because the company’s industry sometimes dictates how geared the capital will be. This is due to the high cost of setting up businesses that personal funds cannot handle, and I am guessing this is why different gearing ratios exist to give a broader view into the business. In this case, not all debts are considered bad debts as long as the business keeps servicing its debts.

Gearing indicates the financial risks associated with a company depending on which side of the ratio it falls. There are different uses of gearing, which also depend on the user of the information. Lenders use gearing to determine whether they give a loan to a company. They generally stay away from highly leveraged companies. Investors use gearing like the lenders as well. A low gearing ratio will be attractive to this category of users.

The most popular gearing ratio is the debt-to-equity ratio, which is equal to total debt divided by total equity. Companies can reduce gearing by selling shares, converting their loans to shares, or reducing costs and increasing profits (this would help generate more cash to reduce the debt obligations).