The Variability of Gearing
When an exam question mentions gearing, it is all too easy to only consider financial gearing (that of interest bearing debt divided by equity – or similar!). The truth is, […]
When an exam question mentions gearing, it is all too easy to only consider financial gearing (that of interest bearing debt divided by equity – or similar!). The truth is, operational gearing is a very equal partner and to have a full discussion about gearing, then both operational and financial must be considered.
Operational gearing analyses the proportion of operating costs that are fixed in nature. If a company has high operational gearing, then a high proportion of operating costs are fixed.
There are various ways of calculating operating gearing (as there are for financial gearing). The one you choose in the exam depends upon whether there is a comparative or not. If there is an industry average comparative then you should calculate your gearing so as to match the comparative, otherwise the choice is yours (as long as you specify what you have done in words as well as numbers).
For me, the most intuitive calculation is as follows…..
Operational gearing = Operating fixed costs/Total operating costs * 100% (by operating costs, we mean cost of sales plus overheads – basically all costs above operating profit on the statement of profit or loss. Sometimes the question will be as explicit as to say variable costs and fixed costs on the P&L)
So what is the problem with high operational gearing?
Well, high operational gearing means that the business’ operating profit is sensitive to changes in sales volume. Put simply, if sales volume drops, revenue drops and so operating profit drops quickly as the fixed element of operating costs do not change. Equally, if sales volume rises, revenue rises and operating profit rises quickly as fixed operating costs do not change. High operational gearing leads to ‘variability or volatility of operating profit due to changes in sales volume’. Operating gearing is therefore a measure of ‘business risk’.
What is the connection between operational gearing and financial gearing?
Think of a basic statement of profit or loss:
Cost of Sales
If operational gearing is high then operating profit can be variable (or volatile) due to high business risk.
This has to have an impact upon the finance decision that management make. If they are considering introducing additional debt finance to the capital structure (ie increase financial gearing and so financial risk), then the finance charges currently showing on the P&L will increase. This in turn will decrease a key financing ratio ‘interest cover’ (shown above). Interest cover is often included within covenant agreements the business makes with providers of debt finance and is often set at a minimum level. If minimum interest cover is breached then this can lead to the finance being recalled by the lender.
Therefore, if the business already has high operational gearing and so volatile operating profit, then the business risk will already be putting strain on the minimum interest cover covenant. A decision to raise further debt finance will only add to the pressure of maintaining the interest cover above the pre-determined minimum. In other words, the decision to raise debt finance will be adding additional financial risk to a business with high business risk. This does not mean debt finance should not be considered but in the report to management, it is the role of the writer to make management aware of the considerations they should be making in all key financial and business decisions.
In conclusion, if you are given the opportunity in the exam, by way of the information you have been given, ensure you mention both operational and financial gearing and in so doing, mention business and financial risk – both are equally important.