Gearing Ratios: Operational and Financial Gearing

Gearing ratios are the measure of a company’s capital structure. It provides information about a company’s leverage including operational and financial gearing. A business can fund its projects by either debt or equity financing. The proportion of each financing option will affect the cost of capital and the returns of the company. Gearing ratios can be calculated in different ways, but are mainly concerned with the capital employed in the company.

Definition of Gearing

Gearing is a measure of a company’s debt against equity. As the debt and equity can take a different form such as short-term debt form working capital the gearing ratios also vary. Commonly gearing is termed as debt financing against equity financing. Higher debt means a higher gearing or leverage of a company.

Gearing Ratios Calculations

Gearing ratios can be calculated in different ways. A number of gearing and leverage ratios can be included in gearing analysis. Some of the commonly used gearing ratios are given below.

Capital Gearing Ratio = Debt / Equity × 100     or,

Capital Gearing Ratio = Debt / (Debt + Equity) × 100

Here the term debt will include all short-term, long-term debts, along with accounts payable and bank overdrafts.

Some other gearing ratios can also be used in full gearing analysis.

Debt Ratio  = Total Assets / Total Debt

Equity Ratio = Total Equity / Total Assets

Capital gearing is also known as financial gearing. Analysts also use short-term financing against short-term liabilities. The operational leverage or gearing also forms part of the gearing analysis.

Operational Gearing

A company incurs two types of costs; fixed and variable. The proportion of these costs affect the revenue, net profits, and hence shareholders’ wealth. Operational gearing or leverage is the measure of fixed costs against the variable costs. As companies will either fund these costs with debt or equity, the structure will impact the capital gearing.

It can be calculated in different ways depending on the costing method. The commonly used method should include the use of contribution margins against the fixed costs.

Operating Leverage or Gearing = Fixed Costs / Variable Costs         Or,

Operating Leverage or Gearing = % Change in Net Profits / % Change in Turnover

Operational Gearing = Contribution Margin / Net Profits

Contribution margin = Total Sales – variable costs or cost of sales

Working Example

Suppose a company sells 200,000 units of a product with fixed costs of $ 700,000 and variable cost of $ 0.80 per unit. The sale price per unit is $ 8.00.

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We can calculate the operational gearing as:

Contribution margin = 8.00 – 0.80 = $ 7.20 per unit

Fixed cost per unit = 700,000 / 200,000 = $ 3.5 per unit

Net profit = 7.20 – 3.50 = $ 3.70 per unit

Operational Gearing = 7.20 / 3.70 = 1.94 times or 194%.

How to Interpret Operational Gearing

Business managers use the operational gearing measure to find an appropriate selling price. As it looks to cover the fixed costs with revenues and a change in the sale price will change the net profits. A gearing ratio in percentage or absolute term can be used as a starting point to find the optimum level of the sale price in a forecast analysis.

For example, in our working example above a 10% change in the revenue would increase the operating leverage by 19.4%. Conversely, the managers may look to increase the revenue by producing more units or an increase in sales price to maintain the operating leverage.

Suppose two companies have similar sales volumes. The variable and fixed variable costs for both are different. Even if the profits are the same, a 10% change in the sales and subsequently variable costs will produce different operational gearing levels.

 Firm A10% IncreaseFirm B10% Increase
Sales6.06.66.06.6
Variable Costs3.03.31.01.1
Fixed Costs1.01.03.03.0
Profits2.02.32.02.5
Change in Gearing2.3 – 2.0 = 03. Or 30% 2.5 -2.0 = 0.5 Or 50% 

This shows the management can adjust the sales price and seek an optimum between variable costs and fixed costs.

Financial Gearing

Financial gearing is the measure of debt against equity. It indicates the percentage or a divide between a company using debt and equity financing options.

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It can be calculated in a number of ways.

Financial Gearing = Debt / (Debt + equity) × 100

Equity Gearing = Preference Shares + Pong-Term Debts / Ordinary Shares + Reserves

Preference shares are deemed as an obligation for the business, so many analysts include preference shares with debt.

$ in Million
Assets
Non-Current Assets          25.0
Current Assets          13.0
Total Assets          38.0
Liabilities and Equity
Equity
Ordinary Shares Capital and Premium          14.0
Preference Share Capital            2.5
Reserves            1.5
          18.0
Long-Term Loan          11.0
Current Liabilities            9.0
Total Equity and Liabilities          38.0

From the extracted data above, we have the following:

Total Long-Term Debt = 11.0 + 2.5 = 13.5

Total Equity = 14.0 + 1.5 = 15.5

For analysis purpose, preference share is considered as debt. It is one of the prior charge capital.

Thus, we can calculate the financial gearing and equity gearing as follow:

Financial Gearing or Capital Gearing= 11.0/ (11.0 + 14.0) = 0.44 = 44%

Equity Gearing = 13.5/15.5 = 0.87 = 87%

As with the operational gearing, it can also be interpreted with comparisons. The financial gearing analyzed separately for financial and equity gearing provides detailed capital structure analyses.

Gearing Ratio Analysis and Importance

Both operational gearing and financial gearing contribute to the total business risk of a company. Investors and shareholders alike will carefully interpret the business risk in operation and capital structure.

If the company cannot cover the fixed costs, it will be unable to generate enough profits. The management can forecast the change of unit sale price and effect on gearing. As fixed costs cannot be changed easily, the managers will primarily look to adjust the financial gearing to reduce the total business risk. A significant increase in unit price cannot simply mean increased revenue, as it can make the product less competitive in the market.

Financial gearing seeks an optimum between debt and equity financing for the business. The debt is cheaper due to tax-deductible interest costs. High leverage would also mean the risky capital structure of the company that will increase the future borrowing cost further.

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A high capital gearing implies the company has larger portion debt financing than equity finance. Higher leverage poses a default risk of the business, which makes the borrowing expensive. An expensive debt facility will eventually increase the higher total cost of capital for the business.

Gearing ratios should be considered in comparison with industry standards or historical performance analyses of the company. A company with more long-term fixed assets and low cash flows will have higher leverage than a company with more cash flows. Similarly, the company with a higher portion of fixed costs will have greater operating leverage.

Advantages of Gearing Ratio Analysis

Gearing ratio analyses provide information on various business risks. Each type of gearing and leverage analysis is mainly useful for lenders and investors of the business.

  • Operating leverage provides information on fixed cots against variable costs, and measure of net income against fixed assets employed
  • Operating leverage can help managers forecast the change effects of sale price against fixed costs
  • Financial and equity gearing reveal the capital structure of the company
  • It can help balance the optimum between low cost of debt financing and easily available equity financing for the company
  • Gearing structure of the company may reveal important information on the total capital cost of the company
  • Lenders and investors can assess the business risk with gearing ratios

Limitations of Gearing Ratio Analysis

Managers calculate and interpret leverage and gearing differently. Practically business managers cannot alter fixed costs. Operating leverage is a measure that often cannot be controlled by business managers. Similarly, debt financing may not be readily available for business, as lenders look for financial security and collateral. The business capital structure may change with a one-off long-term debt or with an IPO. Historical figures used in capital gearing analysis should be interpreted with latest information.

Conclusion

Gearing ratios offer an overview of the total business risk. The operational gearing offers insights on business operating risk, whereas financial gearing depicts the capital structure of the business. Both operating and financial gearing can be compared with industry standards for a similar size company. Investors and lenders alike can analyze the company’s financial risk with the gearing level.

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