profitability when debt repayments can be easily afforded. However, high gearing is risky as it can cause the following problems:
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Greater pressure on management to sustain or increase profits to pay interest on loans and dividends at the same time.
Reduced dividends for shareholders as payments to lenders of loans must always be given priority.
Greater difficulty raising finance from selling shares as the business is seen as less able to pay high dividend returns and is therefore a riskier investment.
Difficulties in raising additional loan finance from banks who will question the ability of the business to repay loans.
Risk of liquidation if interest payments on loans are not made in full and on time, as the business may be forced to close and sell off all its assets to clear its debts.
Compare long-term debts to the size of equity
Debt capital is the total value of the long-term loans owed by the business. Equity capital is the total value of issued ordinary share capital plus retained earnings.
By comparing the size of debt capital and equity capital (debt/equity ratio), the ability of a business to pay its long-term debts can be assessed.
Formula
Debt capital Equity capital
x 100 = % 1,400,000 | Traction Bikes - Year 1 | Traction Bikes - Year 2 400,000 x 100 = 28.6% 2,000,000
Low gearing refers to having debt capital of less than 50% of equity capital. High gearing refers to having debt capital of greater than 50% of equity capital.
