Leverage or Financial gearing

The financial gearing of a company can be calculated as:

(Preference shares + Interest bearing loans) /ordinary shareholder funds

The interest bearing loans include all long-term and short-term debt obligations, mortgages, lease obligations, bonds and notes payables. The shareholders’ funds represent the funds contributed by the company’s ordinary shareholders.

If a company is able to grow its net income and revenues without a high financial gearing, it means that the company is allocating capital efficiently. The financial gearing of a company must be compared to its peers within the same industry. Companies with financial gearing that is higher than its peers within the same industry mean that it is taking on a greater risk. If the company defaults on its loan, the creditors may call the loan in. In such an instance, the creditors get paid first before the ordinary shareholders of the company. Dividends may also be suspended, causing the share price of the company to fall significantly.