It’s a term that is seen as difficult and complicated, almost like a science for non-financial professionals. Gearing is actually very simple and here we show you how simple.
The key thing to remember is to view the context level of this term. And if we see RISK in there, then we know where we are! This is the one and only thing you need to understand!
Gearing in Practice
Let’s start from the basics: a company will only be able to raise finance if investors or lenders think that the returns they can expect are satisfactory in view of the risks they are taking.
To get a good picture, investors appraise companies by using information that is relevant to market prices and returns. Financial Gearing is one determinant of such information and it poses a lot of confusion in the minds of many analysts, bankers, auditors and management of companies. It impacts directly the value of a share on the stock exchange and therefore the calculation of many ratios used in financial statement analysis.
How we Calculate Gearing
One very common formula is the Debt/Equity ratio:
If a company has no external debt, i.e. its long-term financing comes entirely from equity, then it is a zero-geared company. The more the external debt the higher the gearing.
Is high gearing a good thing? One effect it has is strengthen the Tax Shield of a company, and this is surely a good thing! Tax Shield is very important in Financial Management.
Tax Shield
A tax shield is a reduction in taxable income for a company through claiming allowable deductions. |
Moving from Equity to Debt means less tax is being paid as interest cost is an allowable deduction before taxation, i.e. it is a cost on which no tax is paid, whereas dividends are paid out of profits after taxation, i.e. dividends are not a cost. More cash is made available to shareholders and more cash is available for future expansion.
However, we have to be very careful with this!
Before we explain why, here is an overview of what gearing really is:
Gearing and the Business Cycle
Whether we like it or not the business cycle is a fact of life:
During good times when profits are good and steady, everyone is happy! Debtholders earn their fixed income and there is enough left to pay dividends to the shareholders.
But when there is a downturn and profits are scarce or even non-existent, Debt-holders are still happy because they get their agreed fixed return (if they don’t, they will sell the company assets, realise their investment and invest it in other companies). Shareholders get a dividend only IF there are enough profits AFTER all other obligations have been met. If shareholders are not kept happy, then our shares will be perceived as risky and their price will drop. Not only do we lose prospective shareholders but we also lose prospective debtholders as a result.
So the higher the debt-to-equity (D/E) ratio is, the higher our commitment to pay the fixed cost of D during bad times and so the higher the risk that our shareholders will not be very happy with us! This makes our shares unattractive.
The Gearing Ratio D/E represents Financial Risk and the higher it is the more likely that our shares are perceived as risky!
What Gearing Means
So the higher the gearing the more risky a company is perceived and the lower the value of its shares will be! That will have a direct impact on certain ratios like for example the Price/Earnings ratio!
The higher the gearing the more volatile the shareholders’ return will be as earnings will fall by a bigger proportion than a reduction in operating profits. The reason is obviously the element of loan interest in the profit and loss which must be paid regardless of profit level.
To show healthy gearing, companies must have two fundamental characteristics:
(1) Relatively stable profits
(2) Suitable, not fast depreciating, assets for security
The above two conditions ensure that shareholders are kept happy also in the inevitable bad times of the business cycle.
In Part 2 we will continue with Operating Gearing and look at its relation to Financial Gearing, but in the meantime if you have any questions, then please let us know in the Comments below!