Gearing directly influences a company’s Earnings Per Share (EPS) by affecting net profits through interest expenses on debt. This example illustrates how different levels of gearing can impact a company’s EPS, demonstrating the balance between leveraging debt for growth and managing financial risk.
1. Scenario Overview
Let’s compare two companies, Company A and Company B, that operate in the same industry but have different capital structures. Both companies generate the same operating profit, but Company A is highly geared, while Company B has low gearing.
Financial Data for Both Companies:
| Financial Metrics | Company A (Highly Geared) | Company B (Low Gearing) |
|---|---|---|
| Total Debt | $400,000 | $100,000 |
| Equity | $200,000 | $500,000 |
| Operating Profit (EBIT) | $150,000 | $150,000 |
| Interest Expense | $40,000 | $10,000 |
| Tax Rate | 30% | 30% |
| Shares Outstanding | 10,000 | 10,000 |
2. Step-by-Step Calculation of Net Profit and EPS
A. Company A (Highly Geared)
- Step 1: Calculate Profit Before Tax (PBT)
- Step 2: Calculate Net Profit
- Step 3: Calculate Earnings Per Share (EPS)
Operating Profit (EBIT) – Interest Expense = $150,000 – $40,000 = $110,000
Net Profit = PBT – Taxes (30% of $110,000)
Net Profit = $110,000 – $33,000 = $77,000
EPS = Net Profit / Shares Outstanding
EPS = $77,000 / 10,000 = $7.70 per share
B. Company B (Low Gearing)
- Step 1: Calculate Profit Before Tax (PBT)
- Step 2: Calculate Net Profit
- Step 3: Calculate Earnings Per Share (EPS)
Operating Profit (EBIT) – Interest Expense = $150,000 – $10,000 = $140,000
Net Profit = PBT – Taxes (30% of $140,000)
Net Profit = $140,000 – $42,000 = $98,000
EPS = Net Profit / Shares Outstanding
EPS = $98,000 / 10,000 = $9.80 per share
3. Analysis and Interpretation
A. Comparing EPS Between the Two Companies
| Company | EPS |
|---|---|
| Company A (Highly Geared) | $7.70 per share |
| Company B (Low Gearing) | $9.80 per share |
B. Key Takeaways:
- Impact of High Gearing: Despite having the same operating profit, Company A’s higher interest expenses due to its debt significantly reduced its net profit and, consequently, its EPS.
- Impact of Low Gearing: Company B, with lower debt and interest expenses, retains more of its earnings, resulting in a higher EPS.
4. When Can High Gearing Improve EPS?
In certain situations, high gearing can lead to higher EPS, especially if the company’s return on investment exceeds the cost of debt. This is known as positive financial leverage.
A. Scenario: High Gearing with Higher Returns
Let’s assume Company A increases its operating profit due to successful expansion financed by debt:
- New Operating Profit (EBIT): $200,000
- Interest Expense: $40,000 (unchanged)
Recalculating Net Profit and EPS:
- Profit Before Tax (PBT) = $200,000 – $40,000 = $160,000
- Net Profit = $160,000 – $48,000 (30% tax) = $112,000
- EPS = $112,000 / 10,000 = $11.20 per share
Interpretation:
With increased profits from the debt-financed expansion, Company A’s EPS rises to $11.20 per share, surpassing Company B’s $9.80 EPS. This illustrates how effective use of debt can amplify returns for shareholders.
5. The Dynamic Relationship Between Gearing and EPS
This example demonstrates how gearing impacts Earnings Per Share (EPS). High gearing can reduce EPS due to increased interest expenses, especially if the company’s returns do not exceed the cost of debt. However, when managed effectively, gearing can amplify earnings, leading to higher EPS if debt-financed investments generate substantial returns.
Ultimately, the relationship between gearing and EPS highlights the balance between leveraging debt for growth and managing financial risk. Companies must carefully assess their capital structure to optimize profitability and protect shareholder value.