Gearing: Explained

Many businesses believe that borrowing should be a last resort. In fact, some business owners boast about the fact that their business hasn't needed to borrow any money. But borrowing money isn't always a bad thing. And actually, borrowing money can be beneficial because it means you have more funds to invest.

Borrowing money means that you can take advantage of opportunities that wouldn’t otherwise have been available to you. More importantly, borrowing money also means that you can increase the return on your business investments. Financial experts use the term “gearing” to describe borrowing money to fund your business in this manner.

How does Gearing work?

Let’s say you want to invest £200,000 in residential property to rent out. One way of doing this would be to invest that in one mortgage-free property. However, you could also split that £200,000 into four £50,000 deposits and buy four £200,000 properties using mortgages to cover the rest of the cost.

Buying four properties rather than one makes your investment work harder. Using gearing like this would result in a property portfolio worth £800,000 for your £200,000 investment.

The benefits of Gearing

Gearing can amplify the return on your investment. In our property investor example, it’s likely that by the time the interest payable on the mortgages is taken into account, the rental yield on that £200,000 investment would be roughly the same. However, the potential for capital gains is increased.

Gearing can amplify the return on your investment.

If the property market rises by 10%, the investor with one property would make a £20,000 capital gain. However, the investor with four properties would make an £80,000 capital gain. What would have been a 10% profit has now become a 40% profit.

Gearing isn’t only for property investors, though. A factory owner could borrow money to buy machinery (see our guide on asset finance) and raw materials, increasing their output. As long as that factory owner can find buyers for the additional output this should result in increased profit.

The downsides of Gearing

Although gearing can amplify the returns on your investments it can also amplify your losses.

In the property investor example above, if the property market falls by 10%, the investor with one property would have only lost £20,000 whereas the investor with four properties would have lost £80,000 – or 80% of their initial investment.

In the factory example, if demand for the products reduced, the factory owner would be left with machinery that was no longer needed. However, the money that had been borrowed to buy them and the interest payable on the loan would still need to be repaid.

Gearing Ratios

The gearing ratio of a business is the borrowings of that business expressed as a percentage of its net assets or shareholders funds. Businesses with high gearing ratios are described as being highly geared.

Being highly geared is beneficial in good economic times because you can use that gearing to increase the returns on your investment. However, lowering your gearing ratio makes sense in economic downturns because it reduces your exposure to that downturn.

Bear in mind that although a sensible level of gearing can be a good thing, excessive gearing may mean your business is vulnerable. The property investor might not be able to liquidate their portfolio if the property market started to fall, for instance, and could end up in negative equity. The factory owner could be left with redundant machinery.

The effect of interest

Gearing works well when the interest rates are low, but doesn’t work as well when interest rates are high because the extra interest that you have to pay on the money that you have borrowed will eat into your profits. Clearly, it only makes sense to use borrowed money in your business if your return on that investment is higher than the interest rate that you are paying.

Gearing works well when the interest rates are low, but doesn’t work as well when interest rates are high…

As well as calculating your gearing ratio, you should consider your “interest cover” figure. This is your profit before interest and tax divided by the interest you have to pay.

It’s obviously a good idea to make sure you can cover any interest you have to pay so you want this figure to be as high as possible. It’s also important to remember that interest rates can change so you should build a safety margin into this figure, particularly if you are borrowing on variable interest rates.

Is Gearing suitable for my business?

Gearing is a fairly aggressive business strategy that is used primarily by businesses that are aiming to grow quickly when the economy is growing. But it isn’t without its risks.

If you’re running a small family business and you’re not looking to expand, gearing probably isn’t for you. But if you’re looking to grow your business quickly in a growing economy, using gearing to achieve that is worth considering.

Related Guides:

• How Do Equity Release Mortgages Work?
• How Do You Convert a Residential Mortgage to Buy to Let?
• What is the Mortgage Application Timeline?