sharetrader
Page 1 of 3 123 LastLast
Results 1 to 10 of 29
  1. #1
    On the doghouse
    Join Date
    Jun 2004
    Location
    , , New Zealand.
    Posts
    9,222

    Default Gearing Ratios: Trading Company vs Bank

    The 'Gearing Ratio' is one of the simplest statistics to assess the underlying risk of a company you wish to invest in. An internet search for a definition of Gearing Ratio brings up ideas where 'long term debt' is compared to 'shareholders equity'. I prefer to use the term 'bank negotiated debt'. This is becauue long term agreements with a bank often have a portion of that debt maturing in the current period. It seems wrong to ignore the current portion of that bank debt, even if it is not strictly 'long term'.

    All companies have company assets that are funded by a mixture of owners equity and debt. I have graphically represented this in my typical 'trading company' below:

    Trading Company
    Debt D
    B
    Equity A
    Assets A+(B+D)

    In the table:

    'B' represents the negotiated bank debt
    'D' represents other debt, for example wages owed to employees and bills as yet unpaid to suppliers.
    'A' represents the shareholders equity in the company.

    Our particular company has no other positive equity apart from 'A'. This would be unusual. But complicating the model by bringing other kinds of assets into our model company would only serve to obfuscate the discussion.

    The 'Gearing Ratio' for our Trading company is calculated very simply:

    Gearing Ratio = B/A

    The higher the 'Gearing Ratio', in general, the more risky is the company.

    SNOOPY
    Last edited by Snoopy; 15-04-2017 at 08:43 AM.
    Watch out for the most persistent and dangerous version of Covid-19: B.S.24/7

  2. #2
    On the doghouse
    Join Date
    Jun 2004
    Location
    , , New Zealand.
    Posts
    9,222

    Default

    Quote Originally Posted by Snoopy View Post
    The 'Gearing Ratio' for our Trading company is calculated very simply:

    Gearing Ratio = B/A

    The higher the 'Gearing Ratio', in general, the more risky is the company.
    We now move on to our boutique bank which is still funded by a much larger parent bank. This is why 'B' is retained as a source of debt. However, we now have a new source of borrowings. Money handed over from customers at the counter in the form of debenture investments - C.

    Another change is that our boutique bank lends to customers. From a bank perspective, this loan book is an asset, and is represented in the chart below as 'R' (for receivables).

    Bank
    Debt D
    B
    Customer Debentures
    Equity A
    Receivables (Loan Book)
    Assets (A+R)+ (B+D+C)

    The above looks complex. Yet the size of the loan book and the number of debentures written out for bank customers are largely independent of the underlying financial position of the bank. So when working out the 'Underlying Gearing Ratio' (the term 'Gearing Ratio' on its own is IMO largely meaningless when we are talking about a bank) the formula does not change from the Trading Company case.

    The 'Underlying Gearing Ratio' for our Bank is calculated very simply:

    Underlying Gearing Ratio = B/A

    The higher the 'Underlying Gearing Ratio', in general, the more risky is the bank.

    However, it would be a mistake to compare the 'Gearing Ratio' of a Trading Company, with the 'Underlying Gearing Ratio' of a bank in absolute numerical terms.

    But like with like comparisons certainly are valid.

    SNOOPY
    Last edited by Snoopy; 31-07-2016 at 12:02 PM.
    Watch out for the most persistent and dangerous version of Covid-19: B.S.24/7

  3. #3
    On the doghouse
    Join Date
    Jun 2004
    Location
    , , New Zealand.
    Posts
    9,222

    Default Question of the day

    Quote Originally Posted by Snoopy View Post
    The 'Underlying Gearing Ratio' for our Bank is calculated very simply:

    Underlying Gearing Ratio = B/A

    The higher the 'Underlying Gearing Ratio', in general, the more risky is the bank.

    However, it would be a mistake to compare the 'Gearing Ratio' of a Trading Company, with the 'Underlying Gearing Ratio' of a bank in absolute numerical terms.

    But like with like comparisons certainly are valid.
    We now move on to the bit that I can't answer.

    Suppose our Boutique Bank decided that taking in money from customers over the counter was just too hard. They had amassed a Receivables book that looked solid and a Parent Bank was willing to lend them money (I'll call it B2) in place of those over the counter customer debentures. So the balance sheet of our Boutique Bank is now represented as below:

    Bank
    Debt D
    B
    B2
    Equity A
    Receivables (Loan Book)
    Assets (A+R)+ (D+B+B2)

    Now what is the 'Underlying Gearing Ratio' of our Boutique Bank?

    Is is B/A (as before)?

    Or is it now (B+B2)/A ?

    Comments appreciated, even along the lines that I have proposed the wrong question!

    SNOOPY
    Last edited by Snoopy; 20-09-2016 at 08:39 AM.
    Watch out for the most persistent and dangerous version of Covid-19: B.S.24/7

  4. #4
    On the doghouse
    Join Date
    Jun 2004
    Location
    , , New Zealand.
    Posts
    9,222

    Default

    Quote Originally Posted by Snoopy View Post
    Now what is the 'Underlying Gearing Ratio' of our Boutique Bank?

    Is is B/A (as before)?

    Or is it now (B+B2)/A ?

    Comments appreciated, even along the lines that I have proposed the wrong question!
    No-one has bitten on this. So I am going to continue my ramble and see where it leads.

    A more general question is: How is risk reflected in the Gearing Ratio? Because if the Gearing Ratio is not a measure of risk, what is the point of measuring it? Now, a hypothetical situation.

    Let's say the ANZ bank (the country's largest) announced tomorrow that all depositors funds would be unwound, and henceforth the domestic base of loan money would be replaced by a cash facility from the new Nikko-USA-Euro bank. All the new money would come from Tokyo Housewives, Belgian Dentists and Tea Party capitalists all desperate to improve on the zero interest rates being offerred on their banks at home. Naturally all this new money would be hedged to the New Zealand dollar to avoid wildly swingly exchange rates creating an uncertainty in the NZD cash available. How would this affect the risk profile of ANZ bank?

    For starters nothing has changed on the loan book side of the business. But wouldn't it feel strange to be able to borrow for business expansion, yet not be allowed to run a cash account to manage daily cashflow, or be allowed to invest the proceeds of your business success back into the ANZ as your company grows? I sense there is something that I will term "crowd wisdom" that is in the back of the mind of bank customers. I am saying there is some comfort in the knowledge that tens of thousands of New Zealanders have put their own hard earned cash in a bank, and tens of thousands of New Zealanders, taken as a collective can't be wrong. OTOH, a triumvate conglomurate, headed by the Americans, Europeans and Japanese would seem distant, maybe without the best interests of New Zealand at heart? They would have creditworthiness. But could they really be trusted? For the average punter on the street, my instinct says no. My gut feeling is that taking out the "deposit side" of a bank would increase the risk. Depite the backing from the strongest economies on the planet, such a bank wouldn't be seen as a proper bank anymore. I can't rationalise that position. Yet, I would have a strong pull to close my accounts with the ANZ under this circumstance and move to another bank.

    Anyone agree or disagree with my position?

    SNOOPY
    Last edited by Snoopy; 02-08-2016 at 09:46 AM.
    Watch out for the most persistent and dangerous version of Covid-19: B.S.24/7

  5. #5
    Member
    Join Date
    Mar 2016
    Posts
    105

    Default

    Quote Originally Posted by Snoopy View Post

    A more general question is: How is risk reflected in the Gearing Ratio? Because if the Gearing Ratio is not a measure of risk, what is the point of measuring it? Now, a hypothetical situation.

    SNOOPY
    Snoopy, I think the first thing you need to consider is what "risk" is. From the firm's point of view, the risk you are considering is the risk of not being able to meet their debt obligations, or default risk.

    It then makes sense that if a firm is at low risk of default, they could then afford to take on more debt to finance the business than a firm that is at a higher risk of default as they have the ability to to service higher levels of debt and/or can borrow more cheaply than the higher risk firm. Therefore the statement that higher gearing means more risk does not hold true, and in reality may mean the exact opposite - a high gearing ratio indicates less risk.

    Next, we consider that the goal for any firm in terms of their capital structure is to maintain an optimal capital structure. This ensures they can deploy their capital most efficiently to maximise their returns on their capital and therefore maximise the share price of the firm. To do this, the firm needs to minimise their cost of capital, and this means altering the mix of debt and equity, and hence their gearing ratio. It may be that for certain firms, such as banks, their cost of borrowing is so significantly lower than their cost of equity, that their optimal capital structure is almost entirely debt, and thus they have very high gearing ratios.

    The proper way of measuring the "risk" of a firm would therefore be to determine how far the firm is away from it's optimal capital structure, as a sub-optimal firm will not maximise it's value and thus not be operating in it's most efficient state. This means that the likelihood of the firm running into financial distress is higher than if the firm is optimised, and thus the firm is more "risky".

    From the above, you can see that a firm's gearing ratio is not a good measure of risk at all. Comparing the gearing ratio of firms in the same industry may lend some insight, but this is only somewhat useful. Perhaps another method would be to measure the change in gearing ratio over time, and the effect of the change in the ratio on the firm's return on capital to gauge whether the firm has an optimal structure or not, and therefore whether the firm has become more or less risky over time. This would also only be useful if the cost of debt and cost of equity remains constant over time, but these are also dynamic, so complicates the analysis. This is also only an indirect observation though, rather than being a direct quantification of risk.
    Last edited by Grunter; 18-08-2016 at 07:22 PM.

  6. #6
    On the doghouse
    Join Date
    Jun 2004
    Location
    , , New Zealand.
    Posts
    9,222

    Default

    Quote Originally Posted by Grunter View Post
    Snoopy, I think the first thing you need to consider is what "risk" is. From the firm's point of view, the risk you are considering is the risk of not being able to meet their debt obligations, or default risk.
    Generally, I agree that the risk I am interested in is 'default risk'. However, I see a bank 'default risk' and a trading company 'default risk' as different.

    A trading company is the much simpler case. A trading company have negotiated their own bank loan terms. A trading company knows all about trading in their own sphere. Thus a trading company uses their market knowledge to manage their profits and cashflows in light of their pre-negotiated bank loan obligation.

    OTOH a bank must manage risk on two fronts.

    FRONT 1: If a bank makes a loan to a trading company, then the bank is taking on a risk outside of their own sphere. Yes a bank will have industry knowledge. But this knowledge is gained from many customers, and thus represents an 'industry average knowledge', rather than 'customer specific knowledge'. Looking at one specific loan case , IMO it is the bank that is taking far more risk than the trading company taking out that loan from the bank. But of course the bank isn't just making one loan to one customer. The bank is making many loans to that same industry. And many loans in one industry portfolio lowers the overall portfolio risk (provided there is indeed diversification of conditions across the many loans).

    FRONT 2: A bank is taking in funds from the public (term deposits), whereas a trading company does not (except for maybe long term company specific bonds that might be traded on the debt markets - not an issue in the day to day running of the trading company). Let's say our bank is making a loan to a company producing an automated production line for making fridges in China. Suddenly NZ gets foot and mouth disease, consumer confidence collapses, and consumers as group need their deposit money to pay down debt of other members of this consumer group. Now I think we can agree there is very likely no connection between building a production line for making washing machines in China and foot and mouth on New Zealand farms. But because these two have nothing in common, this introduces a 'funding risk' for the bank loans. A risk where one side wants out of the loan contract for reasons completely unrelated to the project the funds are being used for. I would argue there is no such equivalent risk for an ordinary trading company.

    So a trading company must deal with a 'default risk' on one front. The trading company can reduce their risk by having fewer transactions in compatmentalised markets, in which they can use their expertise for better understanding of the business dynamics.

    A bank must deal with a 'default risk' on two fronts, either subtley different (Front 1) or completely different (Front 2) from the trading company. The bank can reduce their risk by having many borrowing and lending contracts across many customers on different terms.

    SNOOPY
    Last edited by Snoopy; 15-04-2017 at 08:53 AM.
    Watch out for the most persistent and dangerous version of Covid-19: B.S.24/7

  7. #7
    On the doghouse
    Join Date
    Jun 2004
    Location
    , , New Zealand.
    Posts
    9,222

    Default

    Quote Originally Posted by Grunter View Post
    Snoopy, I think the first thing you need to consider is what "risk" is. From the firm's point of view, the risk you are considering is the risk of not being able to meet their debt obligations, or default risk.

    It then makes sense that if a firm is at low risk of default, they could then afford to take on more debt to finance the business than a firm that is at a higher risk of default as they have the ability to to service higher levels of debt and/or can borrow more cheaply than the higher risk firm. Therefore the statement that higher gearing means more risk does not hold true, and in reality may mean the exact opposite - a high gearing ratio indicates lessrisk.
    I see your point Grunter, but I do not agree with your conclusion. IMO a higher gearing ratio always means more risk for any specific company.

    However I do take your point that risk is not the same for all industries.

    I want to introduce the concept of a "robust market" on one hand and a "fickle market" on the other hand.

    A utility (for example) may have much more certain cashflows - operate in a 'robust market' - and so be able to take on more debt than a company with more volatile cashflows (operating in a 'fickle market') . So utilities, and some say a bank is a utility, generally might operate at higher debt levels and so have higher underlying gearing ratios. A bank operating on 'more debt' in a 'robust market' is therefore increasing their risk perhaps up to the level of a trading company operating in a 'fickle market' or even beyond. A 'robust market' may have an underlying lower risk. But operate at higher and higher gearing ratios in a 'robust market' and eventually you will increase our bank's risk to higher than that of a trading company operating in a 'fickle market'.

    SNOOPY
    Last edited by Snoopy; 16-09-2016 at 03:37 PM.
    Watch out for the most persistent and dangerous version of Covid-19: B.S.24/7

  8. #8
    On the doghouse
    Join Date
    Jun 2004
    Location
    , , New Zealand.
    Posts
    9,222

    Default

    Quote Originally Posted by Grunter View Post
    Next, we consider that the goal for any firm in terms of their capital structure is to maintain an optimal capital structure. This ensures they can deploy their capital most efficiently to maximise their returns on their capital and therefore maximise the share price of the firm. To do this, the firm needs to minimise their cost of capital, and this means altering the mix of debt and equity, and hence their gearing ratio. It may be that for certain firms, such as banks, their cost of borrowing is so significantly lower than their cost of equity, that their optimal capital structure is almost entirely debt, and thus they have very high gearing ratios.

    The proper way of measuring the "risk" of a firm would therefore be to determine how far the firm is away from it's optimal capital structure, as a sub-optimal firm will not maximise it's value and thus not be operating in it's most efficient state. This means that the likelihood of the firm running into financial distress is higher than if the firm is optimised, and thus the firm is more "risky".
    I am familiar with the concept of 'optimal capital structure'. With such a concept a company can be sub optimal if it has either 'too much debt' or 'too little debt'. Clearly though, a company that has 'too little debt' is less likely to default, not more likely to default! So I can't agree with your proposal to use optimal capital structure to determine risk.

    With a bank I think it is important to distinguish 'underlying debt' (total debt minus the customer loan book) verses 'underlying assets' (total equity less the customer deposit book) and 'total debt' verses 'total assets'. With a trading company the 'total gearing ratio' is important, while the 'underlying debt has no meaning. But with a bank it is IMO the underlying debt (or underlying gearing ratio) that is very important. The total gearing ratio is interesting, but I think that depends on 'net interest margin', (again a concept that has no meaning in a trading company being used for comparison).

    If you have a 'high interest margin', that means that your customer deposit book can support more loans than otherwise might be expected. But 'interest margin' is IMO an undifferentiated financial commodity that is open to being undercut by competitors. So I would be careful assuming a 'high interest margin' bank or finance company will always be able to operate with those interest margins at the same high levels.

    SNOOPY
    Last edited by Snoopy; 16-09-2016 at 04:00 PM.
    Watch out for the most persistent and dangerous version of Covid-19: B.S.24/7

  9. #9
    On the doghouse
    Join Date
    Jun 2004
    Location
    , , New Zealand.
    Posts
    9,222

    Default

    Quote Originally Posted by Grunter View Post
    You can see that a firm's gearing ratio is not a good measure of risk at all.
    No one indicator is ever entirely satisfactory. Yet despite the limitations that I have acknowledged, I don't feel you have made the case for a firm's gearing ratio not being a good measure of risk.

    Perhaps another method would be to measure the change in gearing ratio over time, and the effect of the change in the ratio on the firm's return on capital to gauge whether the firm has an optimal structure or not, and therefore whether the firm has become more or less risky over time. This would also only be useful if the cost of debt and cost of equity remains constant over time, but these are also dynamic, so complicates the analysis. This is also only an indirect observation though, rather than being a direct quantification of risk.
    I think the fact that the cost of equity and debt changes with time is one of the reasons most (all?) companies taking out term loans have gearing covenants agreed to with their bankers. Manufacturing (for example) and banking markets are both dynamic. But this doesn't mean you should not use gearing ratios to measure risk. Indeed it is quite the opposite In my view. The gearing ratios are there because both banks and trading companies operate in markets that are dynamic, and the gearing ratios provides the risk buffer to offset that.

    SNOOPY
    Last edited by Snoopy; 16-09-2016 at 04:11 PM.
    Watch out for the most persistent and dangerous version of Covid-19: B.S.24/7

  10. #10
    On the doghouse
    Join Date
    Jun 2004
    Location
    , , New Zealand.
    Posts
    9,222

    Default Answer of the day

    Quote Originally Posted by Snoopy View Post
    We now move on to the bit that I can't answer.

    Suppose our Boutique Bank decided that taking in money from customers over the counter was just too hard. They had amassed a Receivables book that looked solid and a Parent Bank was willing to lend them money (I'll call it B2) in place of those over the counter customer debentures. So the balance sheet of our Boutique Bank is now represented as below:

    Bank
    Debt D
    B
    B2
    Equity A
    Receivables (Loan Book)
    Assets (A+R)+ (D+B+B2)

    Now what is the 'Underlying Gearing Ratio' of our Boutique Bank?

    Is is B/A (as before)?

    Or is it now (B+B2)/A ?

    After taking six weeks to reflect on my own question, I am prepared to put down an answer. I made a previous post about "Crowd Wisdom" affecting risk. It all sounded good when I wrote it, but I am not sure it is important in the context of this question.

    My answer is that our boutique bank still has underlying gearing of B/A.

    The problem with this answer is that if the parent bank:

    1/ lends our boutique bank extra funds on top of the original loan, OR
    2/ makes a new larger loan in place of the original loan plus

    then the incremental requirement that 'we shareholders' know about is the new loan 'in total'. In terms of my 'letter model', the new loan is for 'B+B2'. But we shareholders only know the new 'B+B2' total. We don't know how much of the new loan is in the 'B' or 'B2' components. In fact it is not clear if the boutique bank itself knows this!

    This means that as analysts we have to start using a 'rule of thumb' to determine 'B'.

    SNOOPY
    Last edited by Snoopy; 20-09-2016 at 09:13 AM.
    Watch out for the most persistent and dangerous version of Covid-19: B.S.24/7

Bookmarks

Posting Permissions

  • You may not post new threads
  • You may not post replies
  • You may not post attachments
  • You may not edit your posts
  •