Once businesses are operating they have two main sources of reasonable sums of money for investment, growth and development of the firm:
- Loan capital from banks, and other institutions (Debt)
- Share capital and reserves, including retained profit (Equity)
Most firms operate using a mixture of borrowed capital and their own finance. There are advantages and disadvantages to both sources.
|Loan capital||Once repaid, still have the assets bought. There are now no more charges to be met.||Have to pay interest, even if there is no profit. Interest payments reduce profit.|
|Share capital||No interest. Dividends optional.||Share issues to raise capital can be costly. The number of shares that can be sold is limited by regulations. An AGM is needed to increase the number available.|
Share capital and retained profits are free of fixed charges; only dividends need to be paid. However, this form of capital may be limited. Relying on it alone may slow growth.
Loans, however, cost a company money in interest payments, but a lack of loans can stifle growth.
The balance between loans and share capital is important. This leads to the concept of the gearing of a business.
Gearing measures the proportion of capital employed that is provided by long-term lenders.
Which develops further into the gearing ratio.
This is sometimes known as the debt equity ratio.
What is loan capital? All monies that have been borrowed and interest has to be paid. It will include long-term bank loans, debentures, overdrafts etc. It does not include debtors or creditors; they are interest free.
The gearing ratio value can vary between 0 and 100%. What do individual results mean?
|0 - 25%||Probably too low. Growth may be being slowed by a lack of capital. Firm could be planning a take-over, however. Look at the cash position. If this is high then a take-over or merger may well be round the corner.|
|25 - 75%||Acceptable range|
|75% +||Could be too high. Dangerous in difficult trading conditions. Any rise in interest rates could increase interest payments significantly. In the extreme this could lead a firm into liquidation. It is like a house-owner having too high a mortgage payment and having to sell up because they cannot afford the interest repayments.|
A firm is said to be highly geared if the gearing ratio is over 50%; in other words loans represent more than 50% of capital employed. The higher the gearing ratio: the higher the degree of risk. A lower geared company offers a lower risk investment and as a result they can normally negotiate additional loans more easily and at a lower interest rate than highly geared company.
Improving the ratio
Remember, gearing is a symptom: so changing it in its own right has little value. Obviously, its improvement will depend whether it is currently too high or too low.
Too low: The firm could borrow more money provided there is a suitable investment. Is the real problem behind the low gearing ratio a lack of research or product ideas?
Too high: the firm should attempt to pay off some loans, or raise more share capital. Perhaps the firm is trying to expand too fast.
The gearing ratio of a business will change with time, usually on a regular cyclical basis. It will grow as it invests to expand, and then fall as the retained profits increase as a result of the growth. It will then grow again as the process is repeated with new products etc.
Sources of finance
Sources of finance for a firm will be of one of two types, those that change gearing and those that do not. Some sources will increase gearing; others will reduce it.
1. Methods that change gearing
a) Those that increase gearing:
- Bank loans - Short- or long-term loans from banks. Interest is paid, but the bank has no say in the running of the firm (unless they buy shares, or manage to get a director on the board).
- Commercial paper - a special form of loan where bonds or debentures are bought by specialist financial firms.
- Debentures - a loan instrument.
b) Those that decrease gearing:
- Sale of shares, sometimes at a premium. This will increase shareholders funds. However, the number of shares available to be sold is limited by the regulations of the company which set out its 'authorised share capital'.
- Rights issues. This is where existing shareholders are given the 'right' to buy new shares at a 'special' price.
Follow the link below to see an example of a rights issue.
2. Methods that do not change gearing
- Leasing - the firm does not own the asset; they just rent it. No capital involved, so the balance sheet is unchanged. Costs increase, so profits will fall on the P&L account.
- Sale and leaseback - here the firm sells an asset, and so release cash or capital. The firm leases the asset back, at a cost to the P&L account, but now have the capital to invest in other opportunities.
Follow the link below to see an example of sale and leaseback.
- Debt factoring - this is a short term, one off operation. Instead of waiting for debtors to pay, as per their purchasing contract, the firm sells sell the debt to a factor company, which pays the firm a proportion of the debt in advance. The remainder of the debt is kept as their fee for providing the service and taking the risk of the debt 'going bad'. In many ways it can be considered a sign of weakness, not strength.
Notice that when a business raises more finance, how it achieves this increase will change its gearing. Remember the following:
- Loan capital can be expensive. Interest has to be paid regardless of the market or profit. Repayments have to be made. Eventually, though, when the loan is repaid the firm still has the asset and is now much more profitable. The lender is not an owner, however, so has no say in the running of the business.
- Share capital never has to be repaid and dividends are paid only when there is a profit. Shareholders are owners, however, so sales of additional shares may result in a loss of control over the business.
The implications for gearing must be considered when deciding how to finance an expansion.
Limitations of gearing
As always a series of ratios is required to analyse the situation of the firm fully, plus knowledge of its history. It is very important to know why the ratio has changed.
Calculation of ratios
Follow the link below to get the balance sheet for Student Computers plc and work out the gearing ratio - it will be good practice. Once you have calculated the ratio, follow the answer link below to see how you got on. N.B. Calculate the ratio for both years to compare them.