Principles of Financial Gearing
As an investor it is important to understand the principle of gearing. In the simplest terms, gearing is a technique whereby a person controls a large amount of money using a small amount of money.
Now that we have covered the concepts of inflation and cost of money, gearing will be easy to explain.
Intelligent investors often use this technique in order to maximize their investment returns.
Here are some examples.
Example 1: No Gearing
You have Rk100 lying around. You buy shares with the money and you achieve a return on your investment. You have not geared in any sense as you are using 100% of your own money to control 100% of your asset.
Example 2: Gearing
You have Rk10 lying around. You borrow Rk100 and buy shares with the money. You use your Rk10 to pay for the cost of the Rk100 for the next year. You have geared yourself in a ratio of 10:1. You are controlling Rk100 worth of assets with Rk10.
Example 3: More Gearing
You borrow Rk100 from one financial institution to buy an asset. You borrow Rk10 from a second institution to pay for the Rk100. You use Rk1 of your own money to pay for the Rk10 from institution 2. Your gearing is 100:1 now. You are using Rk1 to control Rk100.
Example 4: Even more Gearing
You borrow Rk120k from an institution and you use Rk100 to purchase a growing asset. You use the remaining Rk20 to service the costs in its entirety. You do not use any of your own money. Your gearing ratio is now infinite.
These examples illustrate the principle of gearing. In the real world, intelligent investors make use of this principle in appropriate instances to maximize the returns on investment. Gearing is something that should be considered when investing. It is a tool to be used as and when appropriate. Too much gearing in some instances can obviously increase risk. Too little gearing in other instances can reduce your returns unnecessarily.
In order to determine by how much one should gear (or not), one needs to consider the cost of money, the expected return on investment, the amount of cash flow available, and thus the amount of acceptable short term risk one can handle in return for long term gains.
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