Gearing

Operating gearing refers to the extent to which the firm's total costs are fixed. Financial gearing concerns the proportion of debt in the capital structure.

We need to avoid some of the confusion possible when using the word gearing. First, we should make a distinction between operating gearing and financial gearing.

Operating gearing refers to the extent to which the firm's total costs are fixed. The profits of firms with high operating gearing, such as car or steel manufacturers, are very sensitive to changes in the sales level. They have high break-even points (the turnover level at which profits are achieved) but when this level is breached a large proportion of any additional sales revenue turns into profit because of the relatively low variable costs (costs that rise or fall as company output or sales change).

Financial gearing concerns the proportion of debt in the capital structure. Net income (after interest) to shareholders in firms with high financial gearing is more sensitive to changes in operating profits. There are two ways of putting in perspective the levels of debt that a firm carries. Capital gearing focuses on the extent to which a firm's total capital is in the form of debt. Income gearing is concerned with the proportion of the annual income stream devoted to the prior claims of debt holders, in other words, what proportion of profits is taken by interest charges.

There are alternative measures of the extent to which the capital structure consists of debt. One popular approach is the ratio of long-term debt to shareholders' funds (the debt to equity ratio). The long-term debt is usually taken as the balance sheet items amounts falling due after more than one year.

        Capital gearing (1)    =       Long-term debt       

                                             Shareholders' funds

This ratio is of interest because it may give some indication of the firm's ability to sell assets to repay debts. For example, if the ratio stood at 0.3, or 30 per cent, lenders and shareholders might feel relatively comfortable as there would be, apparently, over three times as much in net assets (i.e. after paying off liabilities) as long-term debt. So, if the worst came to the worst, the company could sell assets to satisfy its long-term lenders. A figure of over 100 per cent would be a matter of concern (for most types of company/industry).

There is a major problem with relying on this measure of gearing. The book value of assets can be quite different from the saleable value. This may be because the assets have been recorded at historical purchase value (perhaps less depreciation) and have not been revalued over time. It may also be due to the fact that companies forced to sell assets to satisfy creditors often have to do so at greatly reduced prices if they are in a hurry. Also, this measure of gearing can have a range of values from zero to infinity, and this makes inter firm comparisons difficult. The measure shown below puts gearing within a range of zero to 100 per cent as debt is expressed as a fraction of all long-term capital:

        Capital gearing (2)   =                    Long-term debt                    

                                            Long-term debt + Shareholders' funds

Many firms rely on overdraft facilities and other short-term borrowing. Technically these are classified as short-term. In reality, many firms use the overdraft and other short-term borrowing as a long-term source of funds. Furthermore, if we are concerned about the potential for financial distress, then we must recognize that an inability to repay an overdraft can be just as serious as an inability to service a long-term bond. The third capital gearing measure, in addition to allowing for long-term debt, includes short-term borrowing:

        Capital gearing (3)   =                    All borrowing                  

                                            All borrowing + Shareholders' funds