Why does an investor look at gearing?
Ever heard of gearing?
One of the difficulties for an investor is that if they exclusively look at profits or cash flow when making an investment decision then they may be led astray into making a poor investment. There is far more the understanding a business than simply the profits it makes.
Take for example, two businesses. They both produce £100 of profit and cash each year. However the way that these companies were funded are different. To put it more technically the capital structures of the two companies differ.
Company A is funded from £500 of the original owners own cash and £500 from a bank loan. Company B is funded from £500 of the original owners own cash and £750 from debt. The question is, looking at these figures in isolation, and assuming all other aspects of the business are the same, which is the better business?
Return on capital employed
With a bit of knowledge on how to calculate profitability ratios such as ROCE we can immediately calculate how efficient each company is at producing profit from its capital base.
Company A has a ROCE of 10% (100/1,000). Company B has a ROCE of 8% (100/1250). The problem with this assessment is that it fails to look at what makes up that capital structure that supports the level of profit produced.
What is gearing?
Gearing compares the level of debt versus equity in a business. Equity is just a fancy term for the owners cash. Debt is simply bank loans. The formula for gearing is fairly simple. It compares total debt to all the capital in the business (ie debt and equity together).
Going back to the example, Company A has a gearing structure of £500/£1,000 and hence has gearing of 50%. Another term you might hear used is leverage. We can say that Company A has 50% leverage.
Company B has 40% leverage, or is geared to the tune of 40%. This is calculated as £1,000/£1,250.
How do we understand leverage?
Quite clearly, Company B is less geared. With less leverage it is a less risky company. With too much debt, companies can find the debt and interest repayments a struggle. Increased leverage indicates increased risk. It means that more of the business was originally funded from debt.
When comparing two different companies and assessing their profitability you must investigate what the cost is in term of increased risk in investing in the business with higher gearing.