Why Investors Should Watch Gearing

Why Investors Should Watch Gearing

Why investors should watch gearing

The directors of a company arrive at the recommended ordinary dividend by reference to the profits available after meeting the interest on loan and preference capital. Obviously the extent of the prior charges is an important factor influencing the amount of profits available m ordinary shareholders.

Let us assume that a company has profits of A;125,000 before tax and the payment of interest at 5% on the prior charge capital.

If the company is highly geared, say, at 50% as in the case of Company A above, then:

Prior charges receive their fixed 5% (is) interest, or f500,000 x 5% = A;25,000 (is per A;! stock).

Ordinary shareholders are entitled to the remainder, i.e., A;100,000. A;100,000 divided among 500,000 shares = 4s per A;! share.

If the company is low geared, say, at 10% as in the case of Company B above, then:

Prior charges receive theft fixed 5% (is) interest, or f 100,000 x 5 £/ f5,000 (is per £1 stock).

Ordinary shareholders would be entitled to A;120,000. A;120,000 divided among 900,000 shares = 2s 8d per A1 share.

Thus, given a certain level of profits it is an advantage for the ordinary capital to be highly geared since this will produce increased earnings attributable to the ordinary shares and so allow bigger dividends.

In other words, the higher the gearing the better for ordinary shares in times of rising profits.


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