Understanding Gearing And Borrowed MoneyDoes 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.
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. Also related to this subject are:
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