Gearing

Gearing, called leverage in the US and some other countries, measures the extent to which a company is funded by debt. One common definition is:

debt ÷ shareholders funds

Unfortunately, there are other definitions, and the other that is widely used (which many people find easier to understand intuitively) is:

debt ÷ capital employed

which is the same as:

debt ÷ (debt + shareholders' funds)

Regardless of the definition, and there are variations even on debt/equity, it is usual to show gearing as a percentage rather than a fraction.

Debt includes only borrowing, not other debt such as trade creditors. It is not unusual to subtract goodwill from the value of shareholders' funds when calculating gearing. Although this is not universally done, it is logical as goodwill reflects a company's history rather than its current financial strength.

As a general rule debt/equity of more than 100% or debt/capital employed of more than 50% is "high", but there is no cut-off point that is too high. As debt gets higher, profits for shareholders become more volatile for the same reasons as with operational gearing.

A high level of debt is a cause for concern, but it does accelerate profit growth as well as declines. Companies with more stable operating profits can safely take on higher levels of debt, so what is acceptable depends on the business.

Interest cover is a more direct measure of the effect of gearing on the volatility of profits.