Gearing and Reducing balance: Difference between pages

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''Financial gearing'' measures the relative amount of debt in a firm's capital structure.
A basis of allocating costs or allowances across successive time periods by applying a consistent periodic percentage charge to - for example - the reducing net book value of a fixed asset.


Gearing ratios can be calculated in several different ways, so consistency of approach is important.


Two essential bases to define are:
'''Example'''


i. The use of book or market values.
A fixed asset has a cost of $12m,


ii. The use of Debt divided by Equity (D/E) or of Debt divided by Debt plus Equity = D/[D+E].
to be depreciated on a reducing balance basis at a rate of 40% per year.




Historically, use of the D/E version of the measure was more common in the UK.
The depreciation charge for Year 1 would be:


With respect to the Debt figure, practice varies in including or excluding certain items such as cash, short term borrowings, leases, pensions and other provisions.
= $12m x 40%


Practitioners may also adjust the Equity figure, for example to exclude intangible assets.
= $4.8m.




2.
The net book value at the end of Year 1 (and the start of Year 2):


''Operational gearing'' relates to the operating costs of a business, and measures the relative proportions of fixed and variable operating costs.
= 12 - 4.8


= $9.2m.


3.


'Gearing up' refers to increasing the levels of financial or operation gearing - or both - within an organisation.
The depreciation charge for Year 2:


The intention of gearing up is to improve expected net results.
= $9.2m x 40%


The consequence of gearing up is normally to increase risk.
= $3.68m.


Many financial disasters have been a consequence of gearing up (or leveraging) excessively in this way in earlier periods.


The net book value at the end of Year 2 (and the start of Year 3):


== See also ==
= 9.2 - 3.68
* [[Debt equity ratio]]
 
* [[Debt to equity ratio]]
= $5.52m.
* [[Intangible assets]]
 
* [[Leverage]]
 
* [[Leveraged]]
And so on.
* [[Leveraged takeover]]
 
* [[Levered]]
Using a reducing balance basis of depreciation, the net book value never falls to zero (unless the asset is disposed of).
* [[MCT]]
 
* [[Off-balance sheet finance]]
 
* [[Ungeared]]
2.
* [[Ungeared cash flow]]
 
''UK tax.''
 
UK Writing Down tax Allowances are normally available to be claimed on a reducing balance basis.




==Other links==
== See also ==
[http://www.treasurers.org/node/8012 Masterclass: Measuring financial risk, The Treasurer, July 2012]
* [[Depreciation]]
* [[Straight line]]
* [[Sum of the digits]]
* [[Writing down allowance]]


[[Category:Corporate_finance]]
[[Category:Accounting,_tax_and_regulation]]

Revision as of 12:35, 18 March 2015

1.

A basis of allocating costs or allowances across successive time periods by applying a consistent periodic percentage charge to - for example - the reducing net book value of a fixed asset.


Example

A fixed asset has a cost of $12m,

to be depreciated on a reducing balance basis at a rate of 40% per year.


The depreciation charge for Year 1 would be:

= $12m x 40%

= $4.8m.


The net book value at the end of Year 1 (and the start of Year 2):

= 12 - 4.8

= $9.2m.


The depreciation charge for Year 2:

= $9.2m x 40%

= $3.68m.


The net book value at the end of Year 2 (and the start of Year 3):

= 9.2 - 3.68

= $5.52m.


And so on.

Using a reducing balance basis of depreciation, the net book value never falls to zero (unless the asset is disposed of).


2.

UK tax.

UK Writing Down tax Allowances are normally available to be claimed on a reducing balance basis.


See also

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