Degearing

Key Takeaways

• Degearing involves replacing long-term debt with equity to reduce financial risk.
• High debt levels can hinder a company's ability to make timely payments.
• A low net gearing ratio indicates financial stability and lower investment risk.
• Different industries have varying acceptable gearing ratios due to capital intensity.
• Post-2008 recession, many companies reduced debt loads through degearing.
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What Is Degearing?

Degearing is a capital structure strategy where a company replaces long-term debt with equity to reduce interest costs and improve management's flexibility. Firms often do this when the gearing ratio shows debt outweighing equity, which can strain repayment capacity. For investors, changes in gearing and degearing plans can signal shifts in long-term financial strategy and stability.

How Degearing Reduces Financial Risk

A company's capital structure refers to the combination of debt and equity it uses to fund its operations and its growth. A company is highly geared or highly leveraged when a large portion of its capital structure is made up of long-term debt. A company's long-term debt (which is any debt or liability that must be repaid in more than one year) can come in various forms, such as bonds, leasing obligations, and loans.

Degearing is a company's movement away from a capital structure relying on long-term debt. A company's managers will use degearing in an effort to decrease financial risk. The financial risk they are trying to reduce is the possibility that shareholders or other financial stakeholders will lose money when they invest in a company that has debt if the company's cash flow fails to meet its financial obligations. Instead of using debt to raise the money needed to fund operations and growth, the company will seek equity financing from investors by selling an ownership stake in the company in the form of shares.

Factors to Consider When Assessing Degearing

Investors can review a company's net gearing ratio as part of their analysis to determine if a company might be a good investment. This ratio represents the amount of existing equity that would be needed to pay off the company's current debts. To calculate this percentage, divide a company's total debt, including bank overdrafts, by its total shareholders' equity. You can find these figures on a company's balance sheet.

For example, suppose Company ABC has a total debt of $5 million and shareholders' equity of $50 million. This would give Company ABC a net gearing ratio of 10%. This indicates the company should be able to pay off its debt several times over. Lenders and investors would most likely consider Company ABC to be a low-risk investment because its low gearing ratio reflects the company's greater financial stability.

However, be aware that determining a good versus bad gearing ratio for a company often depends on the sector or industry in which the company operates. For example, the oil refining and production industry is a capital-intensive business that requires a lot of fixed assets to generate revenue. Companies in the oil industry often have more debt compared to other companies. Because of this, the gearing ratio for oil producers might be much higher than companies in other industries that are less capital intensive.

Tip

When analyzing a company's net gearing ratio, be sure to compare it to companies operating in the same industry or sector. This apples-to-apples comparison can give you a better idea if the company is at a higher or lower financial risk than its main competitors.

Real-World Examples of Degearing in Action

After the Great Recession of 2007-2009, many banks and the real estate sector had to shed debt and degear. For example, the Royal Bank of Scotland had to sell property assets built up before the recession. This included the sale of £1.4 billion of toxic UK commercial property loans, which it sold to private equity group Blackstone.1

Accounting firm PwC reported there was a significant amount of degearing of bank balance sheets after the economic crisis. As a result, the performance expectations of the pre-crisis era were no longer valid. By some estimates, wrote PwC, as much as four percentage points of banks' pre-crisis return on equity (ROE) was attributable to gearing alone.2