Gearing (or leverage) is the relationship between the debt and the equity in a business – between borrowed money and shareholders’ money. A company with £300,000 total debt and £300,000 of shareholders equity is 50% geared (300/600).
For a company to be highly geared – that is, for it to have borrowed a large amount of money relative to its shareholders’ funds – is not necessarily a bad thing. As long as the return on the borrowed money is greater than the interest payable on it, the shareholders will benefit.
But just as gearing can amplify profits in good times, it can exaggerate losses in bad times – interest on debt has to be paid back regardless of how well or badly a company performs. Geared or leveraged takeovers occur when a takeover bid is made using a high proportion of borrowed money.
• See also: Leverage
• Watch Tim Bennett’s video tutorial: Three ways leverage can boost your returns.