Divestopedia Explains GearingGearing is measured variously by:
- Debt equity ratio
- Debt service ratio
- Equity ratio
- The ratio of debt to shareholders' funds
In essence, gearing ratio represents how encumbered with debt a firm is. The appropriate level of gearing for a firm depends on the sector to which a firm belongs as well as the degree of leverage employed by its peers. Each firm will have a distinctive level.
For example, industries with large and ongoing fixed asset requirement have high gearing ratios, while firms in cyclical industries prefer low gearing ratios. This is not necessarily a conservative financial management policy. Firms with more stable operating profit can safely opt for higher levels of debt.
The effect of gearing on the volatility of profit can be measured by the interest curve. A high gearing ratio is a cause of concern for lenders and creditors as these firms face difficulty in meeting debt repayment schedules during business downturns. As debts get higher, profits for shareholders become more volatile.
To reduce gearing ratio, a firm may sell shares to pay down debt, convert debts into shares or reduce working capital.
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