Does Gearing and corporate debt influence your stock portfolio?
The term gearing indicates the amount of borrowing a company has used to finance it's assets. What is considered the 'norm' will differ between sectors and industries.
For example, it is often the case that a property company will have very high levels of debt - all used to purchase more buildings and land, whereas perhaps a recruitment consultant has lower overheads and is highly cash generative so can pay debts down quickly.
borrowings divided by net assets x 100% = Gearing
Some companies should (like our property company) borrow very heavily to finance purchases and expansion. It makes business sense as long as higher rates of return can be achieved with the money. If for example, a company borrows money at 5% pa but can invest the funds to grow at 8% pa, then obviously the extra corporate debt will be profitable. such action does increase risks though.
If a firm has high borrowings
compared with it's equity capital, then it may become vulnerable in
several ways. Firstly, an economic slowdown may hit profits which are
needed to make interest repayments.
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Secondly, interest rates may rise, causing the interest charge to eat up
larger proportions of the company income and any profits. Such
situations are likely to have a strong impact on the share price.
Thirdly, if a company borrows money to finance a venture which proves to be less profitable than hoped, the company can very quickly be overwhelmed by debt repayments.
As a general rule, high gearing is seen in a much more favourable light during times of falling interest rates. Corporate debt during times of high or rising interest rates can often be detrimental to company profits and therefore to the share price.
There are some industries where high levels of borrowing are very normal (property and construction come to mind) and the market does not penalise such companies for what would seem to be very high debt levels in other industries.
How high is high?
That depends upon what is comfortable to you, the investor. Many monitoring services will relate debt to net asset value as a ratio. In property firms, that number might be over 100%. However, in many other sectors, a number of 60% to 75% might be normal.
As an investor, if you are looking for well run companies that seem to be relatively low in borrowing, a number below 50% might be appropriate. Such a company ought to be able to meet their repayment obligations from sales in almost every circumstance.
It might be worth pointing out that most people that purchase securities will buy 'ordinary' shares in some form. These usually only have rights to assets - in the case of bankruptcy - after all outstanding debt has been repaid from the sale of assets. Thus, the more debt the company holds, the more risk is associated with the investment.
The risk associated with the investment is also increased because of the pressure on the balance sheet. As debt rises, the slightest blip in sales, seasonal or market related can cause a meltdown in the company.
Therefore, it is important to have a feel for how much borrowed money a company can usefully use and make a profit on. Of course, the company also needs to be able to support the debt. For companies that have strong growth and high profit margins, the money can be usefully used, but sooner or later, perhaps as growth starts to slow, it will be important that there is a solid plan in place to reduce this exposure.
Operational gearing is a ratio that is designed to measure how sensitive profits are to sales revenue / turnover.
It measures change as a percentage and specifically, the change in trading profit which comes from a one percent change in sales revenue. Obviously, this also depends on the relationship between fixed and variable costs and profits.
Fixed costs are those that are incurred regardless of sales revenue and are also known as indirect costs. Variable costs are directly reated to sales revenue and are therefore often called direct costs.
Operational gearing = (Sales Revenue - Variable Costs) : Trading profit
or
Operational gearing = (Trading profit + Fixed Costs) : Trading profit
Within finance and the stock market more spefically, borrowings are often refered to as 'gearing'.
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This ratio means that the borrowed money acts as a multiplier. If
performance increases, it will be magnified and results enhanced
further. However, this means that the opposite is also true. If results
deteriorate, the borrowed money will act as a weight and drag
performance down even further.
In other words, borrowed money will either add an extra lever - or mutliplier - to profits. Depending upon trading performance, interest rates and the state of the economy, this can be either a good or a bad thing!
It is this 'lever' effect that causes borrowing to often be referred to as 'leverage'.
A great place to see the impact of this in an investment and corporate setting is by looking at the returns and results in the UK's investment trust market (information here).
In the early years of this century, borrowed money was
also used by traders to enhance their profits. Money would be borrowed
at very low interest rates - often in Japan or America - and then
invested elsewhere. As long as the invested return was above the rate of
interest being charged then profits could be earned. This is known as
the 'carry trade' and proved to be incredibly popular.
However, as we all now know, too much borrowed money can be an
incredible liability to an organisation. When lenders decided that they
could no longer trust other lenders, the 2007 credit crunch forced many
major financial institutions into trouble at almost no notice.
These banks, investment banks and funds could not refinance their borrowing and were therefore declared bankrupt. Therefore, whilst operational gearing can be used to enhance returns, the additional risk can prove to be fatal to a business.
Other fundamental analysis related pages include:
How To Use Risk Analysis To Make You A Better Investor
Some Investment Definitions Explained
Understanding Different Types Of Risk
What Does The Return On Capital Employed (ROCE) Tell Us?
Why Low Risk Can Be Good
Does Correlation Influence Portfolio Diversification?
What Is A Stop-Loss?
How Does Volatility, Standard Deviation and Beta Impact An Investment Portfolio?
What Is Alpha? Can You Outperform The Stock Market?
Learn How Beta And Volatility Impact Your Investment Portfolio