The good, the bad and the gearing

It is ideal to have no debt; ……or is it ?

Even some of the world’s wealthiest people will borrow money to buy their aeroplanes, whilst having significant deposits in the bank.

Why ?

so they maximise their liquidity and have available cash for all eventualities, hopefully for opportunities but equally for those rainy days.

and they are happy to pay the costs and interest, because it will enable them to act on the opportunity.

But on a smaller scale, within our Business World, to raise funds to expand is what we would call ‘good debt’.

Perhaps to buy a company, a new machine or a property.

And ‘bad debt’ is the re-financing of owned assets, although if this is to cover a temporary unexpected ‘blip’, we can call it a good debt…..

Our accountants can guide you through the opportunities, which may seem too good to miss, equally they will help guide you through troubled times.

For a sub £10m t/o business it is important to stick to the rules, that have given you your success, have the correct company structure to cover all eventualities and a simple effective plan covering your short (3 month) and longer (3 year) goals.

The gearing needs to be an integral part of this.

In theory, the higher the level of borrowing (gearing) the higher are the risks to a business, since the payment of interest and repayment of debts are not "optional" in the same way as dividends.
However, gearing can be a financially sound part of a business's capital structure particularly if the business has strong, predictable cash flows.

How can the gearing ratio be evaluated?

• A business with a gearing ratio of more than 50% is traditionally said to be "highly geared".
• A business with gearing of less than 25% is traditionally described as having "low gearing"
• Something between 25% - 50% would be considered normal for a well-established business which is happy to finance its activities using debt.

It is important to remember that financing a business through long-term debt is not necessarily a bad thing!

Long-term debt is normally cheaper, and it reduces the amount that shareholders have to invest in the business.

What is a sensible level of gearing? Much depends on the ability of the business to grow profits and generate positive cash flow to service the debt. A mature business which produces strong and reliable cash flows can handle a much higher level of gearing than a business where the cash flows are unpredictable and uncertain.

Another important point to remember is that the long-term capital structure of the business is very much in the control of the shareholders and management.

To reduce gearing you may focus on profit improvement, cost minimisation, repay loan –term loans, retain profits rather than paying dividends.

Thanks to the Business Board team and tutor2u.net for the content.

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