Gearing: Difference between revisions

From ACT Wiki
Jump to navigationJump to search
imported>Doug Williamson
(Colour change of example headers)
imported>Doug Williamson
(Standardise example titles)
Line 14: Line 14:




<span style="color:#4B0082">'''Example'''</span>
<span style="color:#4B0082">'''Example 1: Calculation of gearing'''</span>


<i>Gearing</i><br />
<i>Gearing</i><br />
Line 21: Line 21:
This is usually known as 'gearing'.
This is usually known as 'gearing'.


<span style="color:#4B0082">'''Example 2: Calculation of leverage'''</span>


<i>Leverage</i><br />
<i>Leverage</i><br />

Revision as of 14:15, 4 December 2015

1.
Financial gearing measures the relative amount of debt in a firm's capital structure.
Gearing is sometimes also known as leverage.


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


Two essential bases to define are:


i. The use of book or market values.
ii. The use of Debt divided by Equity (D/E) or of Debt divided by Debt plus Equity = D / (D+E).


Example 1: Calculation of gearing

Gearing
Assume the values of debt and equity are equal, say USD 1m each.
D/E = 1/1 = 100%.
This is usually known as 'gearing'.


Example 2: Calculation of leverage

Leverage
Using the other calculation with the same inputs (D = 1 and E = 1):
D / (D+E) = 1/2 = 50%.
This is usually known as 'leverage'.


Adjustments to D and E figures
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.
Practitioners may also adjust the Equity figure, for example to exclude intangible assets.


2.
Operational gearing relates to the operating costs of a business, and measures the relative proportions of fixed and variable operating costs.


3.
'Gearing up' refers to increasing the levels of financial or operation gearing - or both - within an organisation.
The intention of gearing up is to improve expected net results.
A consequence of gearing up is normally to increase risk.


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


See also


Other links

Masterclass: Measuring financial risk, The Treasurer, July 2012