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.

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What is gearing?

Gearing, in a corporate finance context, refers to the proportion of a company’s funding that comes from debt relative to equity. It is often used interchangeably with leverage, and is typically measured through ratios such as debt-to-equity or net debt-to-EBITDA. At its core, gearing reflects how aggressively a company uses borrowed money to finance its operations and growth. While debt introduces fixed obligations in the form of interest and principal repayments, it also has the potential to enhance returns to shareholders when deployed effectively.

The fundamental logic behind gearing rests on the relationship between the cost of debt and the return generated from investing that debt. If a company can borrow at a lower interest rate than the return it earns on its investments, the excess return accrues to equity holders. This is often referred to as positive leverage. For example, if a business borrows at 5% and invests in a project generating a 10% return, the spread effectively boosts equity returns. Conversely, if returns fall below the cost of debt, gearing works in reverse, amplifying losses and eroding shareholder value.

It can be used as a strategic tool

Many firms deliberately operate with moderate levels of debt to optimise their capital structure. The concept of an “optimal capital structure” emerges from balancing the tax advantages of debt with the risks of financial distress. Interest payments are tax-deductible under Australian corporate tax rules, which lowers the effective cost of borrowing and makes debt an attractive source of funding compared to equity, which is funded from after-tax profits.

Companies in capital-intensive sectors such as infrastructure, utilities, and property tend to employ higher levels of gearing. This is because they typically generate stable and predictable cash flows, making it easier to service debt. For instance, firms like Transurban (ASX:TCL) and APA (ASX:APA) have historically operated with elevated gearing levels.

Their long-term contracts and regulated revenue streams provide visibility over cash flows, allowing them to sustain higher debt loads while continuing to invest in large-scale projects. In these cases, gearing enables companies to undertake infrastructure developments that would be difficult to fund solely through equity, while also enhancing returns for shareholders.

A great way to do M&A

Another way ASX-listed companies exploit gearing is through acquisitions. By using debt to finance takeovers, companies can expand more rapidly without diluting existing shareholders through equity issuance. If the acquired business generates returns above the cost of debt, the acquisition becomes accretive to earnings per share.

This strategy is commonly observed in sectors such as healthcare, technology, and industrials. However, it requires careful execution, as overpaying for acquisitions or misjudging synergies can lead to significant value destruction, particularly when high debt levels are involved.

Gearing is also central to the business models of certain sectors, most notably real estate investment trusts (REITs). Australian REITs often rely on debt to fund property acquisitions and developments. Rental income provides a steady cash flow to service this debt, while property appreciation can further enhance returns.

For example, Goodman (ASX:GMG) has used a combination of equity and debt to build a global logistics property portfolio. While Goodman is relatively conservative compared to some peers, the broader A-REIT sector illustrates how gearing can be used to scale asset bases and deliver income-focused returns to investors.

In cyclical industries such as mining and resources, gearing plays a more nuanced role. Companies like BHP (ASX:BHP) tend to maintain relatively low levels of debt compared to infrastructure or property firms. This is because commodity prices are volatile, and cash flows can fluctuate significantly.

Excessive gearing in such sectors can be dangerous, as downturns can quickly impair a company’s ability to service its debt. However, even within these constraints, companies may increase gearing during periods of strong commodity prices to fund expansions or return capital to shareholders, before deleveraging when conditions weaken.

Enhancing ROE

From a shareholder perspective, one of the most attractive aspects of gearing is its ability to enhance return on equity. By reducing the proportion of equity in the capital structure, a company can generate higher returns on the remaining equity base, assuming profitability is maintained.

This is particularly appealing in low interest rate environments, where the cost of debt is relatively cheap. Over the past decade, many ASX-listed companies have taken advantage of historically low borrowing costs to increase leverage, refinance existing debt at lower rates, and invest in growth initiatives.

The risks of excessive gearing

However, the benefits of gearing must be weighed against its risks. High levels of debt increase a company’s financial risk, particularly in the face of economic downturns, rising interest rates, or unexpected operational challenges. Interest payments are contractual obligations, and failure to meet them can lead to severe consequences, including insolvency.

This risk became evident during periods of financial stress such as the Global Financial Crisis, when highly leveraged companies were forced to deleverage rapidly, often through asset sales or dilutive equity raisings.

Interest rate risk is another critical consideration. As central banks adjust monetary policy, the cost of servicing debt can change, particularly for companies with floating-rate borrowings. In a rising rate environment, higher interest expenses can erode profits and reduce the benefits of gearing.

This dynamic has been particularly relevant in recent years as global interest rates have increased from historically low levels, prompting many companies to reassess their capital structures and prioritise balance sheet strength.

Credit ratings also play an important role in how companies manage gearing. Maintaining an investment-grade credit rating allows companies to access debt markets at more favourable rates. As a result, many ASX-listed companies target specific gearing ranges to align with rating agency expectations. Deviating too far from these targets can lead to downgrades, increasing borrowing costs and limiting financial flexibility.

Another dimension of gearing is its signalling effect. Moderate levels of debt can signal confidence from management in the stability and profitability of the business. Conversely, excessive gearing may raise concerns among investors about financial risk and sustainability. This perception can influence a company’s share price, particularly if investors believe that debt levels are unsustainable or that a capital raising may be required.

Conclusion

Ultimately, the effective use of gearing depends on the nature of the business, the stability of its cash flows, and the broader economic environment. For ASX-listed companies, gearing is a powerful tool that can be used to accelerate growth, enhance returns, and optimise capital efficiency. When managed prudently, it allows companies to undertake investments that would otherwise be out of reach, while delivering superior outcomes for shareholders.

However, gearing is inherently a double-edged sword. The same mechanism that amplifies returns in favourable conditions can magnify losses when circumstances deteriorate. As such, the most successful companies are those that strike an appropriate balance, using debt strategically while maintaining sufficient financial resilience to withstand economic shocks.

In the context of the ASX, this balance varies widely across sectors and individual companies, reflecting differing risk profiles, growth opportunities, and management philosophies.