FOOL SCHOOL
Getting To Grips With Gearing

August 3, 2005

Gearing is a phrase that is often thrown around in discussions about shares. Like many expressions in the stock market, it can have a number of different meanings, one of the reasons why some find the stock market a little confusing. However, the reality is not half as bad as people might think. Gearing can have two meanings: operational and financial.

Operational gearing means that the company is very sensitive to small changes in one or more aspects of the business. It typically applies to a company with low profit margins so that a small change in the group's turnover, or a small change in its costs, makes a big difference to its profits.

But first of all let's look at the most common type of gearing you'll come across: financial gearing.

Measuring debt

Financial gearing is essentially used to describe the amount of debt a company carries. One with a lot of debt, proportionately compared with other companies, is called highly geared. This is because the debt load magnifies the effect of changes on the business.

Think of it like two homeowners in the same street. Say both houses are valued at £100,000, but one homeowner has a mortgage of £50,000 and the other £90,000. This gives the first one an equity stake of £50,000 and the second person a stake of just £10,000.

One year later imagine both houses have gone up in value by 10%. The guy with the bigger mortgage has seen the value of his £10,000 equity stake (in other words the value of the house minus his mortgage debt) double to £20,000, while the other one has only seen a 20% gain to £60,000.

Some companies also borrow heavily, for example to make an acquisition, or else to invest in developing a fast-growing part of their businesses. If this pays off, it may increase a company's turnover and profits more rapidly than if it had not borrowed any money. This in turn should bolster its market value. That's the theory anyway. In practice, it's reckoned many acquisitions actually fail to create any value.

A company's gearing is commonly expressed as a percentage. This is derived from dividing the amount of debt by the total shareholder's funds, or book value of the business. Perhaps this gearing principle, of both the operational and financial kind, is best illustrated by the recent history of certain airline.

Flighty operations

Looking at the operational side, the top part of the profit and loss account shows just how sensitive the airline is to small changes.

	Year 2 £m	Year 1 £m	% change
Turnover	8,940	8,892	0.5
Less: Operating costs	8,856	8,450	4.8
Operating profit	84	442	-81%

A very small increase in turnover was outweighed by a bigger rise in costs to give a massive 81% fall in profits. With an operating margin of only 0.9% during Year 2, it is clear that small changes in two large numbers can have a massive impact on the difference. Here's what happened the year after:

	Year 3 £m	Year 2 £m	% change
Turnover	9,278	8,940	3.8
Less: Operating costs	8,898	8,856	0.4
Operating profit	380	84	352.4

Turnover increasing 3.8%, plus costs rising just 0.4%, led to operating profits more than tripling to £380m.

Turning to the balance sheet, this volatility in earnings is then exacerbated by the impact of a large amount of debt. At the end of Year 3, our airline company had £7.0b of debt but only £3.3b of shareholders' funds. This means its level of gearing was 212% (7b/3.3b). There are no hard and fast rules as to what level of gearing is considered excessive but most investors get twitchy above 100% and many have tolerance levels far below that.

During Year 3, the interest charge on our company's debt amounted to £297m, a little more than the previous year. This was a big drag on the profits. If we ignore exceptional items, the middle bit of the profit and loss account looked like this.

	Year 3 £m	Year 2 £m	Year 1 £m
Profit before interest & tax	445	164	531
Less: Interest charge	297	272	265
Profit (loss) before tax	148	(108)	266

That whopping interest bill transforms Year 1's modest profit into a significant loss for Year 2. So the company has to earn nearly £300m a year to pay the banks before the shareholders get a look in. That's why large debts, or heavy financial gearing, can be such a burden.

Of course, if and when things turn round and profits start to go up, then shareholders will make out in a big way. But will they? What happens if things continue to get worse? It is a fact of life that many companies with low margins also have a lot of debt, partly to improve returns to shareholders.

That is why earnings can be so sensitive to relatively small changes in some of the major parameters. Thus, before investing in a particular company, it is worth checking out the group's gearing, on both an operational and financial basis. Heavily indebted companies with low margins are best avoided.