Syllabus A. Role Of The Senior Financial Adviser A2. Financial strategy formulation

A2b. Gearing considerations 3 / 9

Syllabus A2b)

Recommend the optimum capital mix and structure within a specified business context and capital asset structure.

High Gearing problems

The higher a company’s gearing, the more the company is considered risky.

An acceptable level is determined by comparison to companies in the same industry.

A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.

A greater proportion of equity provides a cushion and is seen as a measure of financial strength.

The best known examples of gearing ratios include

  1. debt-to-equity ratio (total debt / total equity),

  2. interest cover (EBIT / total interest),

  3. equity ratio (equity / assets), and

  4. debt ratio (total debt / total assets).

Dangers associated with high gearing:

  1. Need to cover high fixed costs, may tempt companies to increase sales prices and so lose sales to competition

  2. Risk of non payment of a fixed cost and litigation

  3. Risk of unsettling shareholders by having no spare funds for dividends

  4. Risk of lower credit rating

  5. Risk of unsettling key creditors

How finance can affect financial position and risk

Financial Position Gearing

Gearing can be a financially sound part of a business’s capital structure particularly if the business has strong, predictable cash flows.

Operational gearing

Operating gearing is a measure which seeks to investigate the relationship between the fixed operating costs and the total operating costs.

  • In cases where a business has high fixed costs as a proportion of its total costs, the business is deemed to have a high level of operational gearing.

    Potentially this could cause the business problems in as it relies on continuing demand to stay afloat.

  • If there is a fall in demand, the proportion of fixed costs to revenue becomes even greater. It may turn profits into serious losses.

    Normally, businesses cannot themselves do a great deal about the operational gearing, as it may be typical and necessary in the industry, such as the airline business.

The normal equation used is:

  • Fixed operating costs / Total operating costs

    In this sense total operating costs include both fixed and variable operating costs.

Interest cover

Interest cover is a measure of the adequacy of a company’s profits relative to interest payments on its debt. 

The lower the interest cover, the greater the risk that profit (before interest) will become insufficient to cover interest payments.

It is:

It is a better measure of the gearing effect of debt on profits than gearing itself.

A value of more than 2 is normally considered reasonably safe, but companies with very volatile earnings may require an even higher level, whereas companies that have very stable earnings, such as utilities, may well be very safe at a lower level.

Similarly, cyclical companies at the bottom of their cycle may well have a low interest cover but investors who are confident of recovery may not be overly concerned by the apparent risk.