BUSS3 A* Evaluation - High Gearing is Good – Sometimes!

What is the right level of gearing for a firm? Read many outdated business studies textbooks and they probably warn that gearing is too high if it is over 50% and that such “high gearing" is a warning sign of potential financial problems for a firm.Well, possibly. But I've come across many firms in my business past that have thrived with levels of gearing much higher than 100%. In fact, when you look at most venture capital-backed takeovers or management buy-outs you'll find that most of the funding used to finance the business is debt. Many well-established multinationals operate with gearing well above 50% and investors hardly bat an eyelid?So how can high gearing be good for a business?

First, let's be clear about what we mean by “gearing".

The term is used in business studies to refer to the proportion of debt that is used in the overall financing of a firm. An alternative (and more formal) name for gearing is the “debt-equity" ratio, and it is one of the most fundamental measures in corporate finance. It is a great test of the overall financial strength of a firm, but it needs to be used with care. Another problem is that there are several ways of calculating gearing, which can cause some confusion although each approach is based on the same principles.

Gearing measures the mix of funds in the balance sheet and makes a comparison between those funds that have been supplied by the owners (equity) and those which have been borrowed “debt".

So, to provide a simple illustration: if a firm has equity finance of £1million and debt of £500,000, then its gearing (debt/equity ratio) is £500,000 / £1,000,000 = 50%.

One difficulty arises when deciding what is meant by “debt". Does it include a bank overdraft or amounts owed to trade creditors? Traditionally, debt is taken to all debt that is provided to the firm by banks and other financial institutions (i.e. all interest-bearing debt) – so that would include a bank overdraft if it is a permanent feature of a firm's sources of finance. To make it easier (and aid comparison between firms and between periods) most analysts just take long-term borrowings as the debt figure.

What should be used as the total for equity finance? A good approach is to take the total for capital employed (from the balance sheet) and add to it the total of long-term debt. But there are other ways – just pick one and stick to it.

So what is high gearing?

A AQA Chief Examiner in a recent revision guide (after incorrectly stating the formula for gearing) states that:

“If borrowed funds comprise more than 50% of capital employed, the company is considered to be highly geared. Such a company has to pay interest on its borrowing before it can pay dividends to shareholders or reinvest profits, and it may experience problems borrowing money".

This is lazy analysis from the Chief Examiner and illustrates poor understanding of business reality (as well as misunderstanding how dividends are paid!)

The issue with gearing is not the level (percentage) as such, but whether the firm in question is able to finance the costs (interest) and repayments (cash flow) associated with the debt.

In terms of the BUSS3 exam, evaluating the level of gearing is all about application – what is the strategic strength of the business and how well does it perform financially (think – profit quality and strength of cash flows).

Not convinced? Still think that gearing of 50% is too high?

Well, take a firm which generates a high operating profit each year and enjoys strong, predictable cash flows. It might benefit from very high levels of debt and be handle with ease the interest payments (high “interest cover"). The debt in question might also be long-term in nature with repayments spread long into the future. High gearing would be no problem whatsoever and it might find it pretty easy to borrow further. 50% gearing? Pah!

High gearing can also be good for shareholders. Why? Because most shareholders are looking to maximise the return on their investment. So why should shareholders have to provide all the financing for a firm? If borrowing is available at attractive rates, then it ought to be used (that's how venture capitalists make such high returns).

Let's just explore this a little further. Why should shareholders (equity finance providers) like their firm to have debt finance?

One key reason is that long-term borrowing is cheap compared with the rates of returns that shareholders require.

A 10 year loan for a firm with high profit quality might only have an interest rate of 5-10%. An extra benefit is that the interest cost payments can be offset against profits before corporation tax is calculated – which makes the debt even cheaper! Shareholders typically look for much higher returns than 7-10% p.a. Most of the venture capitalists I worked for wanted around 25-30% p.a.

Another good reason for having debt is that as the borrowing is repaid, the overall value of the business left to shareholders increases.

Say we buy a business for £2million and finance it with £1million of equity and £1million of long-term debt. At the point of purchase, the shareholder value is £1million (= the value of the business less than borrowing liability). But once the borrowing has been repaid, the entire value of the firm belongs to the shareholders.

Now can you see how high gearing might be a good strategy for shareholders?

So, beware lazy comments from examiners and others who like to put the fear of god into students when they explain how high gearing (“>50%) is bad for a business. It might be, but it depends on the nature of the business and the ability of the firm to pay its way.

High gearing can be good for shareholders – sometimes.