Definition of 'Gearing'
Gearing can be used to increase a company's return on equity (ROE). This is because a company can use debt to finance investments that generate a higher return than the interest rate on the debt. However, gearing also increases a company's risk because it increases the likelihood that the company will be unable to meet its debt obligations.
There are two main types of gearing:
* Financial gearing: This refers to the relationship between a company's debt and its equity.
* Operating gearing: This refers to the relationship between a company's fixed costs and its variable costs.
Financial gearing can be increased by taking on more debt. This can be done by issuing new debt or by using cash to repurchase shares. Operating gearing can be increased by increasing the proportion of fixed costs in a company's cost structure. This can be done by investing in new equipment or by increasing the size of a company's workforce.
The level of gearing that is appropriate for a particular company will depend on a number of factors, including the company's industry, its financial situation, and its risk appetite.
In general, companies with a high level of operating gearing are more sensitive to changes in sales volume than companies with a low level of operating gearing. This is because a company with a high level of operating gearing will have a higher proportion of fixed costs, which will remain the same regardless of the level of sales. As a result, a decrease in sales volume will have a greater impact on the company's profits than it would for a company with a low level of operating gearing.
Companies with a high level of financial gearing are more vulnerable to changes in interest rates than companies with a low level of financial gearing. This is because a company with a high level of financial gearing will have a higher proportion of debt, which will be more sensitive to changes in interest rates. As a result, an increase in interest rates will have a greater impact on the company's profits than it would for a company with a low level of financial gearing.
Gearing can be a useful tool for managing a company's risk and return. However, it is important to understand the risks associated with gearing before using it.
Do you have a trading or investing definition for our dictionary? Click the Create Definition link to add your own definition. You will earn 150 bonus reputation points for each definition that is accepted.
Is this definition wrong? Let us know by posting to the forum and we will correct it.