Gearing: What is it and how can companies exploit it to their advantage?

You may hear a company talk about its gearing. Generally only when it has a low level of gearing, of course. But what is gearing, why are ASX-listed companies either under geared or over geared and what is an appropriate level?

In this article, we explore these questions.

What is gearing?

Gearing is a financial leverage technique used to increase the potential return of an investment. It is achieved by borrowing money to purchase additional investments in order to increase the amount of capital available for investing.

Gearing in general can be used in a variety of ways, including purchasing stocks or real estate, developing business ventures and more. Generally, when investors use gearing they are seeking to widen their portfolio and spread risk over multiple investments.

For companies that use gearing, they are looking to grow too and finance such ambitions. In choosing debt over equity as a financing options, they avoid dilution, gain a tax shield (because interest payments are tax-deductible) and they can increase their Return on Equity (ROE) too. They may also be less vulnerable to hostile takeovers, as any acquirer would have to assume the company’s debt.

What is an appropriate level of gearing?

This is a difficult question because there is no ‘one size fits all’ answer. The right level used is usually determined by the investor’s risk tolerance and goals.

But, as a general rule, some investors may be concerned if debt levels are close to (or exceed) its equity. This is determined by certain ratios, particularly the Debt/Equity ratio.

A higher ratio indicated a greater risk, but potentially a greater return dependant on the company’s sector.

Low gearing can be a good and bad thing

A company being undergarded signals to potential investors and lenders that the company is financially stable and confident enough in their future prospects to take on more ownership through equity financing.

But should a company need debt financing, having lower gearing boosts the company’s credit rating and chances of obtaining loans or investments at favourable rates.

Additionally, it may make the company eligible for tax breaks, as many governments and organizations offer incentives for businesses that commit to taking on higher levels of equity financing.

This said, if a company needs a lot of finance and is relying primarily on equity finance, there’ll be a lot of shareholder dilution.

High gearing is risky, but there are some benefits

Debt financing isn’t a bad thing in and of itself.

Keep in mind that there’s no shareholder dilution, repayments are gradually made over longer time frames and that interest is tax deductible.

Nevertheless, companies that leverage too much debt can become overburdened with interest payments especially when interest rates rise fast. They may be unable to handle unexpected expenses or downturns in the economy and therefore might be forced to close their doors.

When overburdened with debt, companies might be able to renegotiate their deals but may be at the mercy of their creditors. If creditors think the only realistic way to get their money back is to send the company into administration, they’ll have no hesitation to pick that option. That is what happened with Regional Express (ASX:REX) earlier this year.

Always consider a company’s gearing

It’s important for companies to carefully consider their overall financial strategy before taking on debt. This is because it can result in both considerable losses or substantial gains depending on market conditions and investment decisions made by the investor.

And it is also important that investors consider a company’s gearing too before making investment decisions. A company overly geared can easily go belly up, and equity investors can be at the back of a very long queue, waiting to get their money back – and they may not at all.

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