Operating and financial gearing

Operating gearing measures how much a company’s operating profit moves when its revenue moves. The thing doing the moving is fixed costs: they stay where they are while revenue changes, so every kwacha of contribution gained or lost lands straight on the profit line.

The two forms answer slightly different questions. The first describes the cost structure — how much of the cost base is committed. The second measures the effect that structure has, as a multiple.

Take a business with revenue of ZMW150,000 and cost of sales of ZMW100,000, of which 75% is variable. Operating profit is ZMW50,000, and interest of ZMW30,000 leaves ZMW20,000 before tax. Now put revenue up by 10%.

Revenue rose 10% and operating profit rose 15%. The operating gearing is 25,000 ÷ 100,000 = 25%, or 15% ÷ 10% = 1.5 times. Cut revenue by 10% instead and operating profit falls by 15% — the amplification works in both directions, which is why high operating gearing is described as business risk rather than as an advantage.

How much of it a company has is mostly decided by its industry. A copper mine, a cement plant or a hotel carries enormous fixed costs and cannot avoid high operating gearing; a trading business that buys stock as it sells it is nearly all variable and barely notices a downturn in the same way.

Financial gearing measures how much of the capital structure is debt. A company funded entirely by shareholders is ungeared; one carrying substantial borrowings is geared, and it has taken on financial risk on top of whatever business risk it already had.

There are four ratios in common use and they measure the same thing against different denominators, so their thresholds differ. Read which one a question wants before answering it.

Preference share capital sits with the debt in these ratios, not with the equity, despite the name. What the ratio is measuring is prior charge capital — finance that has to be served before the ordinary shareholders see anything — and a fixed preference dividend behaves like interest from that point of view.

A ratio on its own says very little. Compare it against the industry: 40% might be conservative for a utility with predictable revenue and reckless for an exploration company. And compare it against the same company’s own history, because the direction of travel is usually more informative than the level.

Interest cover asks a more direct question than any gearing ratio: how many times over can this year’s operating profit pay this year’s interest? It looks at the flow rather than the balance, which is what a lender worries about.

Three times is generally treated as adequate and seven times as comfortable. Below two, a single bad year takes the company past the point where it can service its debt out of trading.

Return to the business from the first section, which has ZMW50,000 of operating profit against ZMW30,000 of interest — cover of 1.67 times, already thin. Watch what a 10% move in revenue does to it.

A 10% change in revenue has become a 37.5% change in the profit shareholders own. The two gearings have multiplied together: fixed costs turned 10% into 15%, and then fixed interest turned 15% into 37.5%.

Gearing can be measured on book values or on market values, and the two can describe the same company in completely different terms.

Take a company with ZMW50 million of ordinary share capital in ZMW0.40 shares now trading at ZMW2.00, ZMW40 million of ZMW100 preference shares quoted at ZMW72, and a ZMW20 million bank loan.

On book values the company is highly geared at 55%, past the 50% threshold and above an industry average of 40%. On market values it is conservatively financed at 16%. Nothing about the company has changed between the two columns.

The difference is almost entirely the ordinary shares. Their book value records what was subscribed when they were issued; their market value records what the business has become worth since. Successful companies therefore look progressively more geared on book values every year they succeed, which is the wrong signal entirely.

Market values are the better measure and the one WACC uses. Book values keep their place because loan covenants are usually written on them, and because an unquoted company has no market value to use — but where a question offers both, say which you have used and why.

Gearing is a ratio, so it can be moved from either side — reduce the debt or grow the equity — and the choices are not equally quick.

• Repay debt from cash generated, or from selling an asset the business does not need.
• Renegotiate the terms — extending the maturity does not reduce the borrowing, but it can rescue the interest cover.
• Stop taking on further debt, and fund the next round of investment from retained earnings instead.
• Grow profits, which lifts both the share price and the market value of the equity, and lowers market gearing without repaying anything.
• Cut costs, which frees cash to repay borrowings and improves the cover at the same time.

What excessive borrowing actually costs a company is worth being able to state plainly, because it comes up as a short written requirement.

None of that argues for having no debt at all. Debt is the cheapest finance a company has, and an ungeared company is leaving that cheapness on the table. The question is where the balance lies — and whether there is a level of gearing that is genuinely optimal is the argument the next step takes up.