Using ratios to analyse companies

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12. Gearing

Definition: Borrowings as a percentage of shareholders' funds (actually, there are lots of variations, but we will concentrate on this one).

Significance:

High gearing can be beneficial to shareholders' earnings or very dangerous. Provided the company's return on capital remains higher than its cost of borrowing, and profits are rising, gearing ensures that pre-tax profits will increase faster than operating profits. But if the cost of borrowing rises above the return on capital, or if operating profits or profit margins are naturally erratic, high gearing can easily eliminate shareholders' funds in a highly geared company.

Calculation:

Look in the balance sheet for Short Term Creditors (under Current Liabilities) and for Creditors over 1 year, and add them together. Then look for Shareholders' Funds in the balance sheet. Allow for adjustments (see example below).

Example

• In M&S's case, Short Term Creditors are £1,364m, but the footnotes make it clear that of this the Short Term Borrowings are only £274m, and that is the figure you want.
• Longer term borrowings are £569m.
• So total borrowings are £843m.
• Shareholders' Funds, meanwhile, are near the bottom of the balance sheet at £3714m, although you do need to add in Minority Interests at £21m making a total of £3,735m.

Gearing calculator Total borrowings £  m Total funds £  m   Gearing:       %

Many people would argue that the borrowings figure used should be a net one. By that they mean that you should see how much cash the company has and take that away from the borrowings figure.

• M&S had £736m cash, and if you took that away from £843m borrowings, you get a net figure of £107m which is only 2.86% of shareholders' funds.

1. Why bother with ratios? 2. A word of warning 3. The P&L and the balance sheet 4. Grouping the ratios 5. Profit margin 6. Return on capital employed (ROCE) 7. Sales as a multiple of capital employed 8. Stockturn 9. Debt collection 10. Payment of trade creditors 11. Cash-to-cash cycle 12. Gearing 13. Interest cover 14. Current ratio 15. Quick ratio (acid test) 16. Earnings ratios 17. Dividend ratios 18. Other ratios 19. Sources of information 20. Conclusion

• Magic Numbers