Gearing- Determinants & Its Advantages And Disadvantages

Earlier articles pertaining to same topic as follows:

• The choice of finance/debt or equity decision

• Financial ratios that affects the leverage or gearing of a company

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