Gearing ratios These ratios relate to the basic financial structure of the organization, and concern themselves with the relative proportions of capital provided by equity shareholders and outside lenders, and the effect on earnings on this capital 'mix'. A "low-geared' company is one that is financed predominantly by equity, whereas a 'high-geared' company relies on outside suppliers for a large part of its capital employed. Gearing produces a risk/reward trade-off, because of the disproportionate effect that it creates in shareholders' earnings when profits fluctuate. When profits increase, the fixed interest charges of loan capital will represent a smaller proportion of a bigger cake, leaving a disproportionately large slice of the available cake for the ordinary shareholder; when profits decline, the same fixed interest charges will obviously represent a larger proportion of a reduced cake, leaving a disproportionately smaller slice of the available cake for the equity shareholder. Obviously, the higher the gearing, the greater the potential rewards to the equity holders when profits are rising - and the greater the downside if profits should fall. However, as gearing increases, the security offered by owners' equity contracts, and the risk to the lender increases. Thus the company is likely to find that opportunities to make further borrowings will diminish. There are two types of gearing ratios: income-based and capital-based. The first is most commonly expressed in the form of interest cover, and measures the number of times the fixed interest charge is covered by available profits; The calculation is profit before interest and tax/interest: The standard capital-based gearing ratio is the debt:equity ratio, which can be calculated in two ways - borrowings/owners' equity: The effect of a particular company's gearing level on the profit attributable to its ordinary shareholders can be demonstrated by means of the ratio known variously as the degree of capital gearing or degree of financial leverage - profit before interest and tax (PBIT)/pre-tax profit (PTP): With this ratio, we can predict the increase in PT that would be achieved for any given percentage increase in PBIT (and vice versa). For example, a 10 per cent increase in PBIT would lead to an 11.67 per cent increase in PTP in year 1 (10 per cent x1.167) and 11.05 per cent in year 2 (10 per cent x 1.105). The reader might care to prove these figures for himself, although the mathematics are intuitive. Similarly, if it is possible to break down the operating expenditure into fixed and variable elements, so that a contribution figure can be obtained, a further useful predictive ratio can be derived, called variously the degree of operational gearing or the degree of operating leverage: contribution/PBIT. If we assume, for the purposes of illustration, that CIMA's total operating expenditure in year 2 of £1•79m (i.e. cost of sales £1•2m + distribution and administration expenses £590K) was made up of £1•4m variable and £390,000 fixed costs, then the contribution would have been £2m turnover - £1•4m variable costs=£600,000. The ratio for year 2 becomes 600/210=2.857, and we can use this figure to predict the increase in PBIT that would be expected from any given percentage increase in turnover and vice versa). For example, a 10 per cent increase in turnover would translate into a 28.57 per cent increase in PBIT (10 per cent × 2.857). Once the reader recognizes that contribution is a surrogate for turnover, the mathematics again become intuitive. These last two ratios can be combined to produce a figure which can predict the increase in PT which would follow from any given percentage increase ational gearing, For CIMA year 2. dece ocapitals arides – perational gearing. For CIMA year 2, the calculation is 1.105 x 2.857 = 3.157.. A 10 per cent increase in turnover would give rise to a 31.57 per cent increase in PTP (10 per cent × 3.157). At this remove, the mathematics are perhaps not intuitive, so we shall briefly prove the figure: a 10 per cent increase in turnover = £60,000 additional contribution = £60,000 additional pre-tax profit (the fixed operating costs and interest charges remaining static). £60,000 additional profit on the original £190,000 = 31.57 per cent.