Checklist Description
This checklist outlines how gearing is used as an indicator of ability to service debt.
Definition
Gearing, also known as leverage, is an indicator of a company’s ability to service its debt. Gearing is usually expressed as a percentage and is calculated by dividing the company’s debt by its equity. Gearing shows the degree to which a firm’s activities are funded by owners’ funds versus creditors’ funds. The higher a company’s degree of leverage, the more the company is considered risky. If a company has a large amount of debt in proportion to its equity, this could be a warning that the company may have problems paying its debts in the future. As when using most ratios, an acceptable level of risk is determined through comparison with other companies in the same industry.
The three most common examples of gearing ratios are:
-
The debt/equity ratio (total debt/total equity), multiplied by interest earned (earnings before interest and taxes, divided by total interest).
-
The equity ratio: total equity/total assets.
-
The debt ratio: total debt/total assets.
In derivatives markets, gearing compares the amount of cash spent purchasing an option or a futures contract with the actual value of the underlying position. The more highly leveraged the trading position, the bigger the risk that a minor change in market prices will totally wipe out the investment. Equally, however, a minor change in markets in the right direction could generate large profits in relation to the size of the investment.
Negative gearing is when an investor borrows to buy an asset, but the returns on the asset do not cover the interest on the loan. A negative gearing strategy works when the asset rises in value and creates enough capital gains to cover the initial investment loss. The investor must finance the shortfall until the asset is sold.
Advantages
-
Gearing ratios allow potential investors to judge the viability, liabilities and likely future performance of a company or industry.
-
Gearing ratios permit analysts to read between the lines of financial statements and quantify a company’s strengths and weaknesses.
-
Gearing ratios provide lead indications of potential problem areas and allow corrective measures to be taken.
Disadvantages
-
Gearing ratios may not always reflect the true nature of a company’s accounts, as managers may attempt to gloss over problems.
-
Gearing ratios are only predictive, based on past performance; and cannot take into account future events.
-
Using gearing ratios to make comparisons between companies and industries is not always possible, due to different worldwide accounting standards.
Action Checklist
-
Obtain as much information as you can, and compare a company’s ratios to those of other firms in the same industry, before committing to an expensive decision.
-
Make sure that you have analyzed the gearing ratios in detail. If in doubt, consult an expert analyst.
-
Be sure you thoroughly understand the ratios. Economizing by taking shortcuts or skipping details may cost more in the long run.
Dos and Don’ts
Do
-
When comparing a business’s gearing ratios with its competitors, allow for any material differences in accounting policies between the compared company and industry norms.
Don’t
-
Don’t rely solely on gearing ratios. Use market research to confirm the results. Don’t fall into the trap of thinking that gearing ratios are infallible.
www.qfinance.com