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The Fool's Guide to Gearing

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 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 its business. 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.

This type of 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 example of British Airways (LSE: BAY).

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.

                      2000  1999  % Change

Turnover            8,940   8,892   0.5
Operating Costs     8,856   8,450   4.8
Operating profit       84     442 -81.0

A very small increase in turnover was outweighed by a bigger rise in costs to give a massive 81% fall in profits. Just picture the situation that could arise next year if turnover rises say 5% to £9,387m and costs fall say 2% to £8,682m then operating profits would be £705m. That would be a 740% gain. With an operating margin of only 0.9% it is clear that small changes in two large numbers can have a massive impact on the difference.

Turning to the financial side, this volatility in earnings is then exacerbated by the impact of a large amount of debt. BA has £6.6b of debt but only £3b of shareholders' funds. Last year the interest charge on this debt amounted to £272m, a little more than the previous year and was a big drag on the profits. If we ignore exceptional items the middle bit of the British Airways profit and loss account looks like this.

                               2000     1999
Profit before Interest & Tax   164       531
Interest Charge               -272      -265
PBT                           -108       266

That whopping interest bill transforms last year's modest profit into a significant loss. So BA 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 it? 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.

Where Next?

• Fool's School discussion board
• Fool's Guide to Margins
• How to Value Shares
• How to Read an Annual Report in Five Minutes