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
- Glossary Of Accounting & Finance Terms-Alphabet T
- Financial Ratios on Assessing The LEVERAGE or GEARING Of A Company
- The Debt Or Equity Decision
- Advantages and Disadvantages of Using Economic Value-Added (EVA) As Performance Indicator or KPI
- What Are The Advantages And Disadvantages Of Discentralization Compared To Centralization?
- Balanced Scorecard: Examples of Financial Perspective,KPI
- Charges, Ranking And Debt to Equity Ratio
March 5, 2007
Posted in: Ratio Analysis
2 Responses
thanks
this is very usefull,but please add some data on ratio analysis
Financial Accounting Ratio Analysis | MBA Accounting - March 16, 2008
[...] Which Financial Ratios Have The Most Value(e)What Other Factors Beyond Ratios Need To Be Considered(f)Gearing-determinants-its-advantages-and-disadvantages(g)Ratio-Analysis-Existing and Potential Net Tangible Asset [...]
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