Gearing and the Capital Structure

Gearing and the capital structure

The nature of the capital structure has important implications for financial management purposes, and in this respect, the gearing is an important consideration.

The gearing expresses the relationship between the proportion of fixed interest (loan capital) and fixed dividend (preference shares capital) to ordinary shares. A company with a large proportion of fixed interest and fixed dividend bearing capital to ordinary capital is said to be highly geared.

The importance of the gearing is that fluctuations in net income may have disproportionate effects upon the return accruing to ordinary shareholders in the case of a highly geared company, and hence on the pricing of ordinary shares on the Stock Exchange. Directors looking for stability in the price of the company's ordinary shares will be swayed by this consideration when faced with raising further capital. For taxation reasons, the net cost of debenture interest may be lower than the net cost in dividends of further issues of ordinary shares. Similarly, fixed dividend preference shares may also cost less than issuing ordinary shares. The following example shows the effects of fluctuating net income levels on the return to ordinary shareholders, assuming that the available net income is wholly distributed.

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Read on: The Capital Structure

The capital structure

The capital structure may consist of both share capital and loan capital, and represents the long-term capital available to the company, as distinct from the short-term capital represented by the credit facilities offered by trade creditors and bank overdrafts. Shareholders are regarded at law as owners. The share capital is at risk, and in the event of business failure shareholders may lose all the capital invested since they rank last as claimants on the residual assets of the corporation. By contrast, loan capital is made available by creditors on a long-term basis.... see: The Capital Structure