Business gearing and financial gearing are terms used to explain the volatility of a company and its activities. While the business gearing measures the risk that a company will fail as a result of not making enough contribution to cover for its fixed cost, financial gearing on the other hand is used to measure the risk that a company cannot meet up with interests associated with its debt.
In as much as businesses try their best to live with these situations, care needs to be taken in order to avoid the often fatal consequences that come with high level of gearing.
Before I go on pointing out the dangers of having high level of gearing, I would like to explain these terms in a common language: Business risk and financial risk Business risks are those risks that are inseparable from business. They are inherent by nature. This refers to the risk of making low profits, or even losses, due to the nature of the business that the company is involved in. One way of measuring business risk is by calculating a company’s operating gearing or operational gearing. The formula is contribution/PBIT (profit before interest and tax).
Financial risks are those risks created by having debt in a company’s capital structure. This is the risk of a company not being able to meet other obligations as a result of the need to make huge interest payments.
Dangers of high level of gearing
Operating gearing measures the effects of fixed cost on PBIT and therefore, indirectly measures the impact of high fixed cost on the going concern of a business (i.e. the business ability to survive for yet another year).
• Risk of loosing sales revenue. Companies that have fixed cost that are too high may tend to increase sales price so as to have more contribution that will in turn help reduce fixed cost, and this may drive their customers to their competitors.
• Risk of incurring the wrath of the law. If a company fails to pay its necessary/obligatory dues, concerned parties may institute a court case against them. And if not handled well, may result to the company being forced to liquidation.
Financial gearing measures the effect of interest payment associated with debt on the continued existence of a company. Some of its dangers are:
• Having a park of unsatisfied shareholders. Since the primary objective of every company is to maximize its shareholders return, a company that have little or nothing left to distribute to her shareholders will be having issues with them. And this can be frustrating.
• Low credit rating. Credit rating agencies always work in collaboration with those that associate with a company. They may give low credit rating to companies that are not being viewed favourably by those that have been in contact with them.
• Unsettled payables. Having too much unsettled payables is not a good sign in the right direction of business growth.
• Ultimate closure of a company. The effects of all the above points may ultimately culminate into the closure of a business.
A good way of escaping these dangers of being either over geared or under geared is to engage the service of business and financial risk managers. Their price/fee may be a little bit on the high side but, the result you get is worth the price a thousand times.
Know what your credit score is in order to be on the safer side.