You’ll often hear accountants and investors talking about “gearing” in relation to a company’s accounts usually – or sometimes their own investments.

So what is gearing, exactly and how does it affect the bottom line?

Let’s consider an easy example. If a company can borrow money at, let’s say, 5% per year interest but can use the money it borrows to generate returns of 10%, then it can comfortably cover its interest whilst retaining more profit itself. Obviously, it makes sense for such a company to borrow money if it can continue to borrow and continue to make profits which are higher than the borrowing costs.

The continuity, though, is crucial. The more the company borrows, the higher its gearing is and it has to keep up payments. Otherwise, it risks bankruptcy – or going into administration for a listed company. In other words, continued expansion and success becomes ever more critical, the higher the gearing.

A company’s gearing is usually expressed as a percentage figure, by dividing debt by equity (equity being the company’s fundamental value). So let’s say you run a property company with around £10 million in assets and no borrowings, then that company borrows £10 million for further expansion, then the gearing is now 100%)

In other words, 100% of your company’s employed capital is now derived from borrowing.

Quite how this affects the profit figure will, of course, depend on the ROCE; return on capital employed – or how well you can utilise the cash versus the interest you have to pay back on it. In other words, the lower the percentage gearing figure, the more financially sound the company generally is. On the downside, though, very lowly geared companies generally aren’t as exciting as they aren’t expanding as quickly – but in the bad times, that’s a bit more comforting!

This article was written by David – a financial blogger. He is interested in telling you about everything from the latest payday loan to the newest financial service for SMEs.