What is gearing? The basics

When you’re researching a company, you might come across the term gearing. It sounds technical, but the idea is fairly simple.

Gearing shows how much a company relies on borrowing. In other words, it helps you understand how much of the business is funded by debt, rather than by shareholders’ money or profits the company has built up over time.

This matters because borrowing can be useful. It can help a company invest, expand and grow faster. But it can also make a business more vulnerable if trading becomes tougher.

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Why gearing matters

For you as an investor, gearing is one way to get a better sense of how much financial risk a company may be taking on:

• Low gearing – a company with lower gearing relies less on borrowing. This can make it more financially stable, as it has fewer debts to manage. The trade-off is that growth may be steadier rather than dramatic.
• High gearing – a company with higher gearing relies more on borrowing. This can work well if the business is growing strongly and using that money effectively. But it can also increase risk, because debt still needs to be repaid even if profits fall. That said, higher gearing is not always a red flag. In some industries, borrowing is a normal part of how companies fund their operations and growth.

How to use gearing to see if a company is right for you

Gearing gives you a useful starting point when you’re deciding if a company is right for you to invest in. It helps you consider questions like:

• Is the company taking a cautious or more aggressive approach?
• How well might it cope if the economy weakens?
• Am I comfortable with the level of risk involved?

Gearing works best as a metric when you use it as a comparison. Look at similar companies in the same industry, as some sectors, such as utilities, naturally use more debt. You can also check how gearing has changed over time.

A simple way to think about it

Imagine two companies.

The first has borrowed relatively little. It will have less pressure on its finances, which could help it stay resilient if conditions become difficult.

The second has borrowed more to fund expansion. If that expansion goes well, profits could grow faster, and investors may benefit. But if business slows, the company may come under more strain because it still has interest payments and debt repayments to deal with.

So gearing is really about balance. Borrowing can support growth, but it can also increase pressure.

What this means for you

If you’re new to investing, looking at gearing can help you understand what kind of company you’re buying into.

A highly geared company may offer greater growth potential. But it may also be more exposed when markets are difficult or borrowing costs are high. A less geared company may grow more modestly, but it could be more resilient when conditions change.

That doesn’t mean one is always better than the other. It depends on the company, the industry and the type of investor you are. If you prefer a steadier approach, you may feel more comfortable with businesses that use less borrowing. If you’re willing to take on more risk in search of higher returns, you may be more open to companies with higher gearing.

You don’t need to calculate gearing yourself. You can usually find it in a company’s annual report or on investment websites. It may appear as ‘debt-to-equity’ (a ratio that compares borrowing to shareholders’ funds), ‘borrowings’ or ‘net debt’ (total debt minus cash). The most useful approach is to compare the figures with those of similar companies in the same sector.

How gearing influences your decisions

Gearing is a simple measure of how much a company relies on borrowing.

For investors, it matters because debt can increase both potential returns and potential risk. A company that uses borrowing well may be able to grow faster. But too much debt can leave it more exposed when conditions become difficult.

Gearing won’t give you the full picture on its own. But it can help you build a clearer view of a company’s financial position and decide if it fits your goals and attitude to risk.

Read: What risks come with investing? The basics
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Read: The UK stock market - 7 simple questions answered

Important information: investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.