What Is Gearing in Accounting?

A company uses various means to attract customers, gain market share and make money. Using gearing, the business invests in strategic, long-term initiatives and key, short-term projects that will bring more cash into corporate cellars down the road. An organization's gearing ratio provides a clearer idea of liquidity, solvency and profitability.

Definition

Gearing means borrowing at low interest rates and using the money to scout the marketplace for opportunities, seize the most attractive ones and make more cash than it will spend in total interest. "Financial leverage" is another term business-debt specialists use when referring to gearing. A related concept is gearing ratio, which calculates as a percentage an organization's level of long-term debt compared to its equity capital. For example, a business has $10 million in long-term liabilities and $20 million in capital equity. The company's gearing ratio equals 50 percent, or $10 million divided by $20 million times 100.

Relevance

Generally, financial analysts classify organizations with high gearing as speculative because these entities have more debt than equity money and may cope with liquidity and operational tedium inadequately --- especially if they can't make enough money to fund operating activities and lenders no longer want to advance new cash to sustain losing businesses. To ease the financial pain that often comes with high indebtedness, a company's leadership continually monitors things like gearing, liquidity and profitability. Other elements that come into play in the corporate gearing equation include solvency and efficiency, both of which allow department heads to improve internal processes without sacrificing the tenet of production quality.

Finding Common Ground

Corporate managers typically are willing to take all sorts of criticism to improve operating activities, the way department supervisors use company money and tactics to set low-risk clients apart from customers who could default over time. In this quest for operational excellence, senior executives attempt to find common ground on the most reasonable gearing level that can help the company make money without breaking its bank. They do this in tandem with investors, lenders and business partners. This collaboration is essential to ensure stakeholder confidence in corporate leadership's ability to make the hard choices that are necessary for long-term profitability.

Seeking Operational Sovereignty

Accounting gearing may help an affiliate company gain operational sovereignty because the business can raise funds and finance operating activities without bowing to the parent company's liquidity constraints. For example, an American company's Mexico-based publicly traded subsidiary can raise money on financial markets --- such as Bolsa Mexicana de Valores --- and use funds to advance its commercial interests. The subsidiary must still keep the holding company's senior personnel in the loop, but it can do whatever department heads deem strategically sensible to use raised funds and make more money.

References

• Business Dictionary: Gearing
• Business Dictionary: Debt-Equity Ratio
• US Legal: Gearing Law and Legal Definition
• University of West Georgia; Insights into Operating and Financial Leverage; Carole E. Scott; 1998
• Tuck School of Business at Dartmouth College; "Note on Leveraged Buyouts"; Jonathan Olsen, et al.; 2002
• "Financial Leverage"; Dr. Larry Guin, CFA