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Smart Investor: why shareholders should wake up to gearing

Lazy investors ignore gearing – or the level of borrowing – in the companies they invest in at their peril.  

 
Smart Investor: why shareholders should wake up to gearing

Lazy investors ignore gearing – or the level of borrowing – in the companies they invest in at their peril.

Gearing is not just for accountants

The topic of gearing is considered a turn-off by most investors. They may reason that it is dull, of little significance or else is something that the company accountants should be bothered about.

However, this could not be further from the truth because gearing is one of the most significant factors to consider before investing in any company and smart investors will always check that a business is not overly geared before investing in it.

So, what is gearing and why should smart investors take any notice of it?

Gearing is a measure of how big a company’s borrowings are, relative to its size. There are different methods of calculating gearing but the simplest and most effective is the debt-to-equity ratio. This shows how much the company owes (debt) compared to its size (equity) and is calculated by dividing total borrowings (current and long term) by net assets and is expressed as a percentage.

A company with a high percentage is said to be highly geared and has large borrowings (normally from the bank) relative to its size and vice versa for a company with a low percentage.

As for why any of this makes any difference to someone buying and selling shares; gearing costs money in the long run. Firstly there is the financing cost; the cost to service the interest on the loan. The larger the borrowings, the more is paid in interest and for longer. This eats away at operating profit and impacts directly on the bottom line. Many highly geared companies are highly profitable at operating level but this is then eaten away by interest charges  as we have seen at Manchester United recently.

Furthermore the issue of gearing has not been in the spotlight of late because interest rates are at 0.5%, so interest paid on borrowings is generally quite low. This has meant that financing costs have been minimal and companies that are highly geared have not suffered. However, there is a valid argument for interest rates increasing in the medium term due to stubbornly high inflation; indeed interest rates will not remain at 0.5% indefinitely. This means companies that are highly geared may see falls in net profit in future years, not because they are less profitable in day-to-day business, but simply because it is costing them more money to service their borrowings.

A buzz from borrowing to get big

In addition, being highly geared is a breeze during the boom years but when the economic cycle makes its presence felt and the economy slides into recession, suddenly a dip in sales is a problem for companies that are highly geared. Indeed there is a necessity for them to keep sales and margins high just to stay in the black. Being too highly geared prevents companies from increasing market share through acquisition when share prices are low because they cannot afford to do it.

From the above you may wonder why any company in its right mind allows itself to become highly geared. Furthermore the reasons for excessive borrowings are mainly emotional as opposed to logical. Often the board wants to grow the business in order to guarantee itself a bigger pay packet and the prestige of managing a larger company. On other occasions it is simply a lack of discipline during boom years; recessions are considered to be a thing of the past and sales will just keep growing, or so the accountants are told.

National Grid is highly geared

Some sectors are more guilty than others of being overly-geared. Energy is one of the worst offenders; National Grid is currently the most highly geared company in its sector and in the FTSE 100 at a whopping 600%. Indeed some may argue that energy companies such as National Grid can get away with it because they have a vast asset base, enjoy a monopoly and have a product that is required. Furthermore many companies that had low levels of gearing were criticised during the recent boom for not maximising their potential for growth. However, none of this will carry much weight if the company is making little profit, paying out small dividends, charging insane prices and is constantly having rights issues (issuing new shares to raise money from investors).

Of course some borrowing is always required for cash flow purposes and to allow the company to expand, acquire other businesses and fund capital spending. However, borrowings should always be kept to reasonable levels, say of up to three-quarters of net assets. This will ensure that the company does not crash and burn in high interest rates periods and recessions. The gearing ratio may not be as exciting as, for example expansion into emerging markets but, as the smart investor well knows, being smart is not always all that glamorous.

19 comments so far. Why not have your say?

Geoff James2

Oct 19, 2010 at 08:33

Always be sceptical of any article that cites examples from planet football. Planet football is a far away place where the laws of physics and finance we understand simply do not apply.

What the article does not say is that debt can be by far the cheaper option for accessing capital compared to equity, and if profits are sufficient to cover debt repayments then the remaining profit is then shared by a smaller pool of equity holders and so they get more.

I agree that excessive debt can be a problem, but it needs to be taken in the context of free cash and profit margins. It should not just be assumed that debt/gearing is bad.

Regards

Geoff

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Hotrod

Oct 19, 2010 at 09:47

"Gearing" touches a raw nerve with me. I don't mind taking a calculated risk but I don't expect to be ripped off ENRON style by reputable Plc.s

Having learnt from bitter experience I now only invest in companies with very low gearing ratios or preferabling zero long term borrowings. Remember shares are risk bearing whereas bank borrowings are secured against assets with conditions attached.

A company with a strong positive cashflow does not need to capitalise the business in this way. It can raise the required funds by increasing the number of shares on its register (a rights issue, or share placement) and/or it can commit all of its net profit to reserves for further investment. In other words it can run a positive net cash position without paying a dividend.

Unfortunately this seldom happens. IMO. There are two reasons. (1) The directors of Plc.s are in bed with the banks. Next time you read a company annual report just note how many directors are holding or have held co-directorships. (2) Vulnerability: Obviously a company with a strong cashflow and no bank borrowings becomes an interesting target for a predator, but those in charge are not going to see their milch cow sold over their heads if they can prevent it. A high level of borrowings is a definite deterrent.

I can give you two instances where high gearing has worked to the disadvantage of shareholders. Land Securities used to be the most highly respected property company in the UK. However when the credit crunch took hold the perceived value of commercial property plummeted, which put the business in breach of its covenants with the banks. The company was forced to sell huge chunks of its portfolio which it had built up over decades.

Drax power station. When the company was privatised it inherited two conflicting attributes. (a) A profitable market for the electricity it could supply, and (b) generating plant which was nearing the end of its working life. However luck was on their side because demand for north sea gas was outstripping supply, and the new pipeline from Norway was not up and running at that time. So they were able to run the gennys at full chat and make loads-a-money. I think the profit was somewhere in the region of £100 million. So you would have thought that the company would transfer this cash to reserves to pay for the new steam turbines. But they didn't do that. Instead they distributed the money to share holders by what they called a special dividend, only it wasn't really a dividend at all, it was a compulsory share buy back at an enhanced price which they set. The next thing they announced was that they had negotiated a loan of £100 million over four years to pay for the new turbines. The result was that the share price took a dive, so the value of the remaining shares which holders were left with dropped by more than the cash which had been foisted on them.

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Martyn

Oct 19, 2010 at 12:41

Thanks to Geoff and Hotrod for enhancing this thought-provoking article and without any political comment.

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MikeG

Oct 19, 2010 at 14:43

Where can I find a list of all Ftse 100 and Ftse 250 companies with their respective gearing ratio's ???

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Hotrod

Oct 19, 2010 at 15:06

To Mike G

Register with one of these sites:

Hemcott. (Morning Star) Reuters.co.uk. or London Stock Exchange.

Registration is free, without having to divulge to much personal info.

You can also obtain annual reports from: http//orderannualreportseu.ar.wilink.com

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Victor Meldrew

Oct 19, 2010 at 18:35

When I want risk I can bet on small-caps like AFC or Motive Television and get plenty of growth potential, so I don't see the point of buying a safe share made risky with debt. It might suit the management to get cheaper capital by going into debt but to me as a shareholder it's a big negative.

If I want something safe I don't want debt with it either, I'd rather it had a cash pile to help it through 'fat tail' events.

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ISA23

Oct 19, 2010 at 19:51

Hetrod: Thanks for the contribution. I actually enjoyed it more than the main article. The two reasons mentioned are so true, and unfortunately shareholders are always left to foot the bill. ALL my major losses so far have been due to companies being geared in a falling market: European Equity Tranch, Prospect Epicure Japan, Invesco Property, Carpethian, New Star etc etc. Experienced managers running very successful companies with sound business plans have undone years of good work in a moment of borrowing madness. In New Star's case things were so good that the founder decided to pay a special divi of about £1 a share when share price was about £3. Less than a year later we were given just 2p a share when the company was rescued by Henderson!! Investors, beware of three things: Gearing, Gearing, Gearing.

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Ahgy

Oct 19, 2010 at 23:41

Can anybody tell me how high or low gearing effects yields?

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Victor Meldrew

Oct 20, 2010 at 01:44

Just thought I'd mention the famously leveraged hedge fund, Long Term Capital Management, which at one point had $129 billion of debt on assets of $4.7 billion, which made it 'too big to fail' and was bailed out in 1998 when it all went wrong.

It's good that the author states a reasonable limit, of three-quarters of net assets, rather than leave us guessing, but that's too much debt for my liking.

What the Nobel Laureates at Long Term Capital Management didn't know was: anything safe 99% of the time will go wrong 10% of the time.

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Victor Meldrew

Oct 20, 2010 at 02:17

Ahgy, I hope this helps:

Suppose a company has no debt, £100m of capital, and earns 20% on capital.

It makes £100m x 20% = £20m profit.

Now suppose it borrows £100m at 10% interest, giving it £200m capital in total.

Now it makes £200m x 20% = £40m profit before interest.

Interest = £100m x 10% = £10m.

Profit after interest = £40m - £10m = £30m.

So the net result of the gearing is a 50% increase in profit, from £20m to £30.

That means the company can increase the dividend by 50% without changing the number of times the dividend is covered by profit.

The same arithmetic method applies even if you change the numbers.

IMO the problem is with the assumptions which need to be true (or near enough) before you can reasonably apply the arithmetic to real situations.

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Anonymous 1 needed this 'off the record'

Oct 20, 2010 at 06:33

Great comments so far everyone and like some pointed out about their losses investing in geared companies I have also taken an 83% loss on one highly geared investment. Anybody here remember the Investment Trust Warrants which were quite popular in the 1990's.

My bad luck and lack of planning led me to invest in Edinburgh New Tiger Trust which sold it assets and returned 17p in the Pound. But in 1998 I was attracted to gearing again and made almost a 900% gain buying warrants in Fleming Capital & Growth and Fleming Asian the following year

As ISA23 mentioned gearing in a falling market can wipe the floor with you. I am a bit old to be ploughing too much into geared investments now, my last being BTL property sold 2 years ago but my mixture of geared investments along with some good timing and yes, some good luck too turned my three grand into a nice retirement pot in just 10 years.

If i was still young enough and not so close to retirement I would be using the SG Warrants to risk increasing my profits but would be wary right now as to the chance of a correction. Risk can bring reward but looking back I was damn crazy to have 100% of my investment pot in geared investments. Should have a screen name of Amber Gambler I reckon....

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Victor Meldrew

Oct 20, 2010 at 08:51

Ahgy, I hope this helps:

Suppose a company has no debt, £100m of capital, and earns 20% on capital.

It makes £100m x 20% = £20m profit.

Now suppose it borrows £100m at 10% interest, giving it £200m capital in total.

Now it makes £200m x 20% = £40m profit before interest.

Interest = £100m x 10% = £10m.

Profit after interest = £40m - £10m = £30m.

So the net result of the gearing is a 50% increase in profit, from £20m to £30.

That means the company can increase the dividend by 50% without changing the number of times the dividend is covered by profit.

The same arithmetic method applies even if you change the numbers.

IMO the problem is with the assumptions which need to be true (or near enough) before you can reasonably apply the arithmetic to real situations.

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Hotrod

Oct 20, 2010 at 09:38

To Anonymous 1

Looks like you are confusing "Gearing" with "Leverage" they are not the same thing.

"Gearing", the debt/equity ratio,explains how the business is capitalised, with reference to the cost of capital. The difference in costs are often quite small.

"Leverage" quantifies an investors stake as a percentage of a contract. with reference to the underlying risk. The potential for profit or loss is therefore usually very high.

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Anonymous 1 needed this 'off the record'

Oct 20, 2010 at 13:32

Well maybe I was half-right anyway Hotrod, the Split Capital Investment Trust Warrants from Fleming were geared according to the prospectus at the time.

Agree the leverage is a more accurate term for the investment property but I still think of gearing as in automotive terms like the Final Drive Ratios on a rear axle or transaxle. I used those to work out my cruising and top speeds on my custom motors a few decades ago, lol. That's why I used the gearing term (loosely) for my properties like 4:1 or 5:1 depending on the LTV ratio's. Nice result in the end though.

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Penny

Nov 01, 2010 at 11:13

Hotrod,

I still don't quite understand - if you can be bothered - could you explain leverage to me in a little more detail? I can't quite get my head around it.

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Hotrod

Nov 01, 2010 at 21:14

Penney, I am not an accountant or professional advisor but I will have a go.

Suppose company XYZ has 1 million shares in issue which are trading at £1 per share the total capital would be £1,000,000 but it maybe that the book value of the assets of the company (NAV) is £1,500,000. Because of a lack of investor interest the company may decide to borrow a further £1,000,000 from a bank, instead of issuing more shares to raise working capital.

The cost of capital could be accounted for in this way.

Cost of investor relations, maintaining share register, and stock exchange fees. 2% Dividend payments. 2% Total equity costs = 4% = £1,000,000 X 4% = £40,000

Annual interest on bank loan @4% = £1,000,000 X 4% = £40,000

In this case the cost of capital from both sources is the same.

So you could say that the debt to equity ratio is 1 million divided by 1 million multiplied by 1 hundred = 100 therefore the company is 100% geared.

If the company makes an operating profit of 8% after one year the figures break down as follows:

£2,000,000 X 8% = £160,000 - £40,000 bank interest. - £20,000 equity costs - £20,000 dividend payment. £80,000 transfered to reserves.

If however the company makes an 8% loss the loss is compounded by the bank loan. Operating loss @ 8% = £160,000 + £40,000 interest + £20,000 equity costs = £220,000 No dividend paid.

The word "leverage" is used to describe the amount of cash paid up front in relation to the underlying asset value when an investor buys derivitive contracts. Such as Futures, Options, Warrants etc. The investor does not buy the underlying asset until the future settlement day, only the contract. Therefore He/she only pays a "margin" plus commission, until the contract is exercised or expires. Derivitives are very complex and I wouldn't like to explain them any further than that.

Hope this helps.

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Penny

Nov 02, 2010 at 08:13

Thank you for this Hotrod. As an investor I feel I should at least attempt to understand something about the terms that are used.

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Anonymous 2 needed this 'off the record'

Nov 15, 2010 at 00:08

It's quite a sticky subject (referring to both leverage / Gearing) due to it having different meanings within several fiscal areas.

Its nice to see the article giving an insight to gearing, although i would of seen it as a more important issue during the 'heat' of the recession. Its good to see investors aware of possible difficulties occuring or reoccuring in reference to the future

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John Bourke

Dec 30, 2011 at 08:34

It's good to see such informative comments.

With such low interest rates, I would be worried about any business that had zero borrowings and the use of special dividends to create a sensible mix of debt and equity within a profitable and cash generating company is perfectly OK provided the business remains not too highly geared as a result.

When does a company become "too highly geared" is a subtle concept however and the answer is very different for different types of company.

For example, I really like the ability of investment trusts being able to gear up by say 20% above their intrinsic net asset value, because they can tap into the 1% interest rates that would not be available to an individual borrower like me. Aiming for say a 4% return from borrowings at 1% ought not to be very demanding in today's markets!

Land Securities and National Grid are both good examples of businesses that had to make big rights issues in the last couple of years. Rights issues and why they are a problem in terms of fairness to the existing shareholders would be a good topic for a future smart investor article.

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