Financial and operational gearing

This column’s list of red flags that help to identify shares to avoid (Questor Jan 4) has prompted questions about how to measure financial and operational gearing.

For financial gearing, take the sum of long-term debt, short-term debt, any pension deficit, leases and contingent liabilities on the liabilities side of the balance sheet. Subtract from that the sum of cash, short-term investments and any pension surplus on the assets side. A positive figure will point to a net debt pile. A negative one will mean the firm has net cash.

Then take the result and divide it by shareholders’ funds. Express as a percentage. This is the gearing ratio. A high score can mean the balance sheet is stretched, a net cash pile quite the opposite and generally the higher the ratio the riskier the balance sheet.

That said, context is needed. The ratio should then be cross-referenced with interest cover in the profit and loss account. This is calculated by taking the sum of operating profit and interest income and then dividing that figure by interest expense. 

Ideally, interest cover should be two or higher, to provide a buffer in the event of any unexpected future drop in profits.

The diligent investor can also look at the average operating margin over a cycle and assess the range from top to bottom. A lofty, consistent margin means profits should be steady, able to help fund a big debt pile and permit relatively low interest cover (think utilities, consumer staples and tobacco). 

A margin that is high one year and low (or negative) the next means the firm is not ideally suited to a big debt pile and high gearing ratio. 

The shares are likely to be high octane, boom-or-bust material (think airlines, steels, paper and pulp, mining and other capital-intensive businesses). They may be stocks to rent or trade rather than own and nurture over the long term, depending upon the strategy, target returns, time horizon and risk appetite of the investor.

Operational gearing is harder to measure but firms where a small percentage change in sales leads to a much bigger percentage change in profits have it in spades. Beyond that, the accounts offer three potential clues.

First, look for tangible fixed assets (property plant and equipment) on the balance sheet and divide that figure by annual revenues (or even average revenues over a cycle). This measures capital intensity. The higher the percentage ratio, the higher the operational gearing is likely to be.

Second is to check for hefty lease liabilities on that side of the balance sheet, as leases must be paid whether sales and profits flow in or not.

Finally take the capital investment figure from the cash flow statement and divide that by annual revenues (or average revenues over a cycle). 

The higher the ratio the more fixed assets there are likely to be in the business and the greater the operational gearing.

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