### Financial

# Financial Gearing

**Gearing refers to the proportion of a company’s funds that are provided by borrowings on which interest is payable regardless of how well the company performs. If a company has a large amount of loan capital compared to shareholders’ equity, it is said to be high geared. If a company has a small amount of loan capital compared to shareholders’ equity, it is said to be low geared. Gearing has important implications for management because if the company is high geared it means that managers must react quickly if revenues start to fall. Shareholders will also be interested in the level of gearing, because any changes in revenue could have a dramatic effect on their fortunes if the company is high geared. This post provides discussion about financial gearing: The effect of financial gearing [is case example], Ideal Level Of Gearing, and how to calculate gearing ratio**. Read on…

The following case example will demonstrate why this happens.

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**The Effect Of Financial Gearing [Case Example]**

Two companies, Lie Dharma Limited and Putra Limited, each have the same amount of capital in total, but different proportions of share capital and loan capital as follows:

**Share capital: $1 shares
**Lie Dharma Limited = 100,000 & Putra Limited = 250,000

**Loan capital
**Lie Dharma Limited = 200,000 & Putra Limited = 50,000

Equal = Lie Dharma Limited = 300,000 & Putra Limited = 300,000

The annual interest rate on the loan capital is 10 per cent. Notice that two-thirds of Lie Dharma’s capital comes from loans, whereas only one-sixth of Putra’s capital consists of loans.

Suppose that the profit for the year, before interest, amounts to $30,000 for each company. The profit per share (ignoring taxation) can be calculated as follows:

Profit before interest Lie Dharma Limited = 30,000 & Putra Limited = 30,000

[Less]

Interest for Lie Dharma (200,000 x 10%) = 20000

Interest for Putra (50,000 x 10%) = 5000

Profit after interest for Lie Dharma = 10,000 & Putra = 25,000

Profit per share (without tax) for Lie Dharma = (10/100) = 100

Profit per share (without tax) for Putra = (25/250) = 100

**At this level of profits there is no difference in the fortunes of the shareholders**. Although Low Gear Limited has earned more profit after interest, this higher profit has to be shared between a higher number of shares. Therefore the profit per share is the same for both companies.

**Now let us see what happens if the profit before interest doubles to 60,000**. The amount of interest payable on the loans will not alter but the fortunes of the shareholders will change considerably.

Profit before interest Lie Dharma Limited = 60,000 & Putra Limited = 60,000

[Less]

Interest for Lie Dharma (200,000 x 10%) = 20000

Interest for Putra (50,000 x 10%) = 5000

Profit after interest for Lie Dharma = 40,000 & Putra = 55,000

Profit per share (without tax) for Lie Dharma = (40/100) = 400

Profit per share (without tax) for Putra = (55/250) = 220

**The profit per share has more than doubled for both companies, since both have some gearing.** However, the change in profit is magnified dramatically for the high geared company, therefore the returns for shareholders increase considerably. On the other hand, if profits begin to fall then the profit per share will reduce faster with the high geared company than with the lower geared one.

**The managers of a highly geared company must therefore be careful to maintain the level of profits and sales and must react quickly if revenues or profits start to fall**. However, if revenues and profits increase, the shareholders in a highly geared company will be proportionately much better off. This volatility of returns which is caused by the existence of higher levels of gearing reflects the financial risk associated with high gearing. You might also hear a company’s gearing referred to as its financial leverage.

**Is There An Ideal Level Of Gearing?**

The most appropriate level of gearing will depend on the type of business that the company is in. Different types of business bring with them different levels of business risk. Business risk is assessed by the potential variability in a company’s profits from one year to the next.

Which would you say has the higher level of business risk: a company which manufactures luxury fashion goods or a company which manufactures bread? The fashion goods company would be exposed to greater business risk than would a company which manufactures bread, because the potential variability in profits is higher.

Demand for the fashion goods is likely to be more volatile than the demand for bread. The demand for fashion goods would depend on changes in fashion, on the activities of competitors and on the amount of money that consumers have to spend. Demand for bread would probably be more stable, hence this company would experience smaller fluctuations in profit and therefore a lower level of business risk.

We have seen that high gearing leads to high financial risk because of the potentially exaggerated fluctuations in the returns to shareholders. The total risk of a company is made up of its financial risk and business risk. Potential investors and lenders will assess the total level of risk in a company. Generally, for a given level of desired total risk, the higher a company’s business risk, the lower its financial risk should be, that is the lower its desirable level of gearing.

**How To Calculate Gearing Ratio**

There are many different methods that might be used to calculate the gearing ratio. The most important thing is to be consistent and to ensure, if you are comparing gearing ratios, that they have been calculated using the same method.

In this text the following formula will be used:

Gearing ratio=[[Borrowings x preference share capital] / Total capital employed] x 100%

Overdrafts are usually included as part of borrowings, despite the fact that they are not really part of long-term capital.

Preference share capital is usually included with the borrowings in the numerator. You should recall that a preference share is a special type of share which is entitled to a fixed rate of dividend each year. In contrast to lenders, preference shareholders cannot force the company to pay them their fixed annual dividend. Therefore it could be argued that preference shares should not be treated in our analysis in the same way that we are treating borrowings on which interest must be paid no matter how well or how badly the company performs.

However, in practical terms the company must pay the preference dividend in order to maintain investor confidence in the company. Therefore the fixed amount of preference dividend payable each year has the same gearing impact as the annual interest payments that must be met.