Difference Between Gearing and Leverage

Gearing vs Leverage
 

Gearing and leverage are terms associated with the utilization of debt for the purpose of employing those funds in business operations. Gearing and leverage are terms that are so closely related to each other that it is often easy to confuse between the two, or to ignore their subtle differences. The following article explains to the reader what each term means and how they are distinguished from each other.

What is Leverage?

Leverage refers to the amount of funds that are borrowed by a business, which are directed towards investments with the aim of obtaining a high return. Leverage is also used in the financing of assets, such as the use of a mortgage loan in the purchasing of a home, where the borrowed funds are used by individuals to purchase house. The use of leverage within a business occurs when the owners do not possess sufficient funds to carry out their business or investment activities and need to borrow these funds through bank loans, issuing bonds, etc. However, a company must keep in mind the risks of obtaining high levels of debt. If an investor invests a large amount of borrowed funds in an investment that fails, his losses will be magnified, since he will face the loss of the investment and will not be able to repay his debt.

What is Gearing?

Gearing is the measurement of the level of debt alongside the amount of equity held within a firm. Higher the levels of debt utilized, higher the gearing of the firm. Gearing is measured by the use of a ‘gearing ratio’, which is calculated by dividing the total debt by total equity. For example, a firm requires $100,000 for an investment. The firm has capital of $60,000 and borrows another $40,000 from the bank. The gearing for this company would be 1.5. The level of gearing within the firm would be 40%, which is in the safe zone (lower than 50%). The gearing ratio is a useful measure of debt for a firm, and can be used as a warning signal of when to stop borrowing and when to rely on equity funds for risky investments.

Gearing vs Leverage

The main similarity between leverage and gearing is that the gearing ratio is derived from evaluating the levels of debt within the firm. The higher the leverage the higher the gearing ratio, and higher the risk faced by the firm. Lower the leverage, the lower the gearing ratio and risk and, possibly, lower the return for the firm. This is because the use of leverage can magnify both gains and losses, depending on whether the funds are invested wisely.