Problem:
I need guidance on how to calculate gearing using ordinary share, preference share and debt financing and also how to evaluate and make a recommendation on which to use.
Gearing is the relationship between debt and total equity included in the capital structure of a firm. The two items are different due to their characteristics. Debt is the capital amount that must be repaid and for which a certain amount, in the form of interest, must be paid at certain dates. Equity, on the other hand, is not usually recoverable from the company during periods of liquidation and does not always receive constant steady income.
Shares (both preference and common stock) are part of equity. Debt instruments include notes payable, bonds etc. Debt instruments must always been repaid in times of liquidation.
To assess the gearing, of a company, the total debt is divided by the total equity of the firm. For example, assume a firm has $10,000 5% Bonds selling at $11,000 (110%) and $5 par value common shares 100,000 units selling at $29, $2 par value 10,000 preference shares selling at $11. Also the firm had and Earnings before interest and taxes (EBIT) of $100,000.
The debt-to-equity gearing ratio, of the company, will be determinable as below:
In assessing debt-to-equity ratio the optimal value should be below at least 50%. Any value, above 50% means that the firm is heavily geared and much of its income would be paid to the external debtors. It also can trigger additional charges from the shareholders in the form of increased rate of return.
Another gearing measure is the times interest earned ratio. It measures the number of times income is covering the interest payment. Higher values, for the ratio, are desirable. There is usually no target ratio value.