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Tuesday, May 11, 2010

The Implications of High or Low Gearing

We mentioned in earlier posts that gearing is, amongst other things, an attempt to quantify the degree of risk involved in holding equity shares in a company, risk both in terms of the company’s ability to remain in business and in terms of expected ordinary dividends from the company. The problem with a high geared company is that by definition there is a lot of debt. Debt generally carries a fixed rate of investment (or fixed rate of dividend if in the form of preference shares), hence there is a given (and large) amount to be paid out from profits to holders of debt before arriving at a residue available for distribution to the holders of equity.

The more highly geared the company, the greater the risk that little (if anything) will be available to distribute by way of dividend to the ordinary shareholders.

The risk of a company’s ability to remain in business was referred to earlier posts. Gearing is relevant to this. A high geared company has a large amount of interest to pay annually (assuming that the debt is external borrowing rather than preference shares). If those borrowings are “secured” in any way (and debentures in particular are secured), then the holders of the debt are perfectly entitled to force the company to realize assets to pay their interest if funds are not available from other sources. Clearly the more highly geared a company the more likely this is to occur when and if profits fall. Higher gearing may mean higher returns, but also higher risk.


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