An investor invests £1,000 in Blue Moon Limited by buying 1,000 ordinary shares of £1 each issued by the company.
By way of illustration (and assuming no other figures are relevant), this would show on the company’s balance sheet as follows:
| Blue Moon Limited Balance Sheet as at 31 March |
|
| £ | |
| ASSETS (cash and cash equivalents) | 1,000 |
| Less LIABILITIES | (0) |
| NET ASSETS | 1,000 |
| SHARE CAPITAL | 1,000 |
| RETAINED EARNINGS | 0 |
| TOTAL EQUITY | 1,000 |
Blue Moon Limited then takes out a loan of £750, repayable over five years:
| Blue Moon Limited Balance Sheet as at 31 March |
|
| £ | |
| ASSETS (cash and cash equivalents) | 1,750 |
| Less LIABILITIES | (750) |
| NET ASSETS | 1,000 |
| SHARE CAPITAL | 1,000 |
| RETAINED EARNINGS | 0 |
| TOTAL EQUITY | 1,000 |
The accounts above show that when a company takes out a loan, the net assets figure is not affected. The company’s liabilities are increased by the amount of the loan but, as the company’s assets (cash and cash equivalents) are also increased by the loan funds, the net assets remain unchanged. Also, because the company has taken out a loan (debt) rather than issued new shares (equity), total equity is also unchanged.
This is important because the ratio of liabilities to shareholder funds (total equity in the balance sheet), or in simpler terms, the ratio of debt to equity, is an important indicator of the financial health of a company. This ratio is known as a company’s gearing (or leverage). The higher the ratio of debt to equity, the more highly a company is geared.
Gearing is calculated by the formula:
Long term debt (Non-current liabilities) x 100%
Equity (Total Equity)
Looking at the example above, the gearing ratio of Blue Moon Limited after it has taken out the loan for £750 is as follows:
750 x 100% = 75%
1000
This illustrates that, at this moment in time, Blue Moon Limited has a very high level of gearing, i.e. the amount of long-term loan capital is very high compared to the amount of shareholder funds (total equity in the balance sheet) in the company.
Highly geared companies are seen as more of a credit risk by banks, so they might find it more difficult to raise further loans in the future. This is because they have less equity to absorb any losses the company might make. Because shareholders are paid last in the statutory order of priority on a winding up of a company, a company with a lot of equity can make substantial losses before it runs out of money to pay back its creditors. A highly geared company has less equity to protect the creditors and so poses a higher risk.
In addition, a highly geared company will need to make more profits before interest and tax (PBIT) in order to meet the demands for interest payments. This can be especially dangerous when economic conditions are bad or interest rates are high. All of a company’s profit could be swallowed up by the interest payments which need to be made under the terms of any loan agreements. Also, a company with a lot of debt is less likely to have assets which can be secured in favour of any new lender(s) (as these will probably already have been secured in respect of the existing debt).
You might be wondering why a company would choose to be highly geared. Suppose a company has a highly profitable investment opportunity available to it. By borrowing money, it can make a far bigger investment than it could have made if it was just using its own resources. If the investment performs well, all the profit from that investment (after interest has been paid on that debt) will belong to the company. It will have made more money than it could have done if it had only used its own resources. On the other hand, if the investment performs badly, it will have lost more money and it will still have to pay the interest on the debt.
Increasing gearing can also enhance the return to shareholders because raising money through debt finance does not require share dilution through the issue of new shares. A finance professional within a company will often recommend that debt finance should be raised due to the fact that this will have no effect on the returns to shareholders. Issuing more shares on the other hand will mean that the profits are shared between more shareholders.
Consider the following example:
| Balance sheet extract | Low gearing £ |
High gearing £ |
||
| Loans (10% interest) | 10,000 | 50,000 | ||
| Equity | 100,000 | 60,000 | ||
| Total capital | 110,000 | 110,000 | ||
| Profit and loss extract | ||||
| Profit before interest and tax | 25,000 | 25,000 | ||
| Interest paid | 1,000 | 5,000 | ||
| Profit before tax | 24,000 | 20,000 | ||
| Tax (assumed 20%) | 4,800 | 4,000 | ||
| Profit after tax | 19,200 | 16,000 | ||
| Earnings per share | 19.2p | 26.6p | ||
The high level of loan capital compared to equity in the higher geared company improves the earnings per share of the shareholders (earnings is the same as profit).
However, in bad times, gearing works in reverse and is therefore risky. Higher gearing increases the scope for a company to make larger losses, by increasing the size of the company’s operations compared to shareholders’ funds. If borrowed capital is deployed badly, the company may lose much more than if it had deployed only its own money. In addition, the loan interest has to be paid whether a profit is made or not.