Get your Gearing right

Gearing is a term used to describe financial leverage. It is the degree to which things are funded with other people’s money.

The most common example of this is a typical home mortgage. It is rare that anyone can simply produce a briefcase full of cash when they finally decide to buy a home. Gearing allows these people the opportunity to buy a house that they would never be able to afford on their own. So, being in debt is not necessarily a bad thing. Almost all individuals and businesses need to use some sort of leverage to achieve their goals. The key is not to avoid debt completely, but to keep it at the right level. Financing a business venture generally has two options: Debt or Equity

• Debt involves borrowing money that needs to be repaid
• Equity involves selling a portion of ownership in the company

You then need to consider which is more favourable. The answer is both. If gearing (debt) is too high, it can lead to unsustainable levels of interest. If it is too low, the potential for growth and expansion might be getting overlooked. The challenge is in finding the right balance. A big part of this is to consider the changing business environment. In an economic downturn high gearing is particularly dangerous as interest obligations must still be met despite lower revenues. Equity investors on the other hand are simply entitled to a share of profits, so if profit falls, their share falls with it. When considering which level of gearing is right, ask, “How much can I afford to borrow?” If the interest repayments turn the business from a profit to a loss, the level of gearing may be too high. Then again, if it is expected the losses in the short term will result in significantly higher profits in the long term, such a gearing plan could be feasible. There is no one right answer when it comes to gearing, and everything needs to considered on a case by case basis. The trick is to learn how your business ticks, understand the ways that money flows in and out of it, and use that knowledge to find a gearing level that is right for you.   Learn everything you need to know in just one day on our financial literacy course Colour Accounting™. Click here to secure your place. [traininglist slug=”colour-accounting-normal”]  ]]>