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

• Financial Ratios on Assessing The LEVERAGE or GEARING Of A Company
• Glossary Of Accounting &Finance Terms-Alphabet T
• Advantages and Disadvantages of Using Economic Value-Added (EVA) As Performance Indicator or KPI
• What are the advantages and disadvantages of Outsourcing The Internal Audit Department of a Company. Give some KPA/KPI to measure the performance of the outsourced provider.
• What Are The Advantages And Disadvantages Of Discentralization Compared To Centralization?
• The Debt Or Equity Decision
• Balanced Scorecard:Examples of Financial Perspective,KPI