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  Financial Gearing

Introduction to Financial Gearing

Financial gearing takes place while a business is financed, at least in part, through borrowing instead of through finance given through the owners (the shareholders) as equity. A level of gearing of business (i.e. the extent to which it is financed from sources that need a fixed return) is a significant issue in assessing risk. In which a business borrows, it employs a commitment to pay interest charges and formulate capital repayments. In which the borrowing is heavy, this can be an important financial burden; it can raise the risk of the business becoming insolvent. However, most businesses are geared to some extent.

Given the risks included, we might shock why a business would want to take on gearing (i.e. to borrow). One cause might be that the owners have not sufficient funds, so the only method to finance the business sufficiently is to borrow from others. Other reason is that gearing can be employed to raise the returns to owners. This is possible given that the returns produced from borrowed funds exceed the cost of paying interest.

An influence of gearing is that returns to shareholders turn into more sensitive to changes in operating profits. A change in operating profits will lead to a proportionately better change in the ROSF ratio, for an extremely geared business.

The influence of gearing is such that of two intermeshing cogwheels of not equal size (see Figure below). The movement in the larger cog (operating profit) results a more than proportionate movement in the smaller cog (returns to ordinary shareholders).

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Figure: Effect of Financial Gearing

Two ratios are extensively employed to assess gearing:

  • The gearing ratio, and
  • The interest cover ratio.

Gearing ratio

The gearing ratio computes the contribution of long-term lenders to the long-term capital structure of a business:

Gearing ratio = [(Long term non current liabilities)/(Share capital + Reserves + Long term non current liabilities)] x 100

Interest cover ratio

The interest cover ratio computes the amount of operating profit presented to cover interest payable. The ratio may be expressed as follows:

Interest cover ratio = Opeating profit/Interest payable

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