Gearing- Determinants & Its Advantages And Disadvantages

Earlier articles pertaining to same topic as follows:

This article deals with the following:

  • What determines the gearing ratio
  • What is the effect of gearing on profits
  • What are the advantages and disadvantage of gearing

Firstly, what do you think that determines your company’s gearing ratio? Some factors are as follows:-

  • The borrowing powers in your company’s articles of association
  • The existence of charges on your company’s assets
  • The attitude of your shareholders towards control. They may resist attempts to dilute their equity holding and prefer “debt” capital as a source of new finance
  • The relative costs of raising debt and share capital
  • The level of anticipated profits in relation to the fixed interest charges on debt capital.

Secondly, what is the difference between a highly geared company and one which is not?

Generally, when we ignore taxation and profit retention, a highly gearing scenario would produce higher dividends at higher profits and lower dividends at lower profit-levels than a lowly geared company.

Lastly, the following are some major advantages and disadvantages of being an highly geared organization:

Advantages:

  • When profits are high in relation to total fixed-interest charges, the ordinary shareholders in a highly geared company benefit immediately from additional dividends or in the future from the earnings generated by the retained profit
  • It enables a company to increase its capital without dilution of equity and shareholders’ control
  • The interest is tax-deductible

Disadvantages:

  • High gearing is disadvantageous to equity holders when profits are falling since they receive disproportionately less by way of dividends.
  • The company is committed to fixed-interest payments which could cause cash flow challenges.
  • Charges may be placed on company assets and once assets are pledged, further gearing may be accomplished only by offering higher yields to lenders to compensate for lack of security.
  • Gearing demands that management product sufficient profits to pay interest and dividends and meanwhile establish a sinking fund for the redemption of debentures
  • Companies whose income fluctuate ( perhaps their products are elastic in demand) will find it difficult to maintain satisfactory dividend rates and share prices.
  • Investors will be reluctant to subscribe new capital
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March 5, 2007   Posted in: Ratio Analysis

2 Responses

  1. bryan - November 7, 2007

    thanks
    this is very usefull,but please add some data on ratio analysis

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