Capital structure and gearing

When considering capital structure the major consideration is the proportion of debt finance the company should undertake to maintain. This proportion of fixed interest capital to equity or ordinary shares is known as gearing or leverage . The pursuit of an optimum level of debt as compared with equity finance, while an important consideration, is not necessarily the only one that exercises the minds of financial managers. Some analysts assert that the value of the company cannot depend on the manipulation or distortion of financial policy with regard to theproportion of debt finance, but rather depends upon the investment performance and risk characteristics of the particular enterprise.

Despite these views, however, managements have to make decisions on the level of gearing or leverage they want, and may have to justify these decisions to the shareholders. If preference for debt finance results in a high proportion of fixed interest capital, the company is said to be highly geared. A low-geared company has a high proportion of equity capital.

Advantages of high gearing or leverage

A preference for debt finance and therefore high gearing may be justified for one or more of the following reasons:

1. The cost of debt capital may normally be expected to be lower than that of equity.
2. Income-producing assets can be financed without immediate reference to shareholders and therefore without having to justify an increase in equity capital.
3. The creation of new equities may increase the risk of potential loss of control
4. Earnings per shareshould be increased if the fixed-interest capital is used to earn a return in excess of the interest charge, and this benefit accrues to the ordinary shareholders of the company.
5. Gearing or leverage increases the value of the company through the tax advantages of debt finance. Interest payment is a tax-deductible expense.

Disadvantages of high gearing

High gearing can be risky, even to the point of bankruptcy, if earnings are not sufficient to cover additional interest costs. This may result in an increase in the equity capitalisation rate needed to compensate shareholders for the additional financial risks they must now carry. It is normally desirable to cover interest payments at least three or four times by profit before interest (ie, profit before interest should be three or four times as high as the interest payments).

Many companies take a cautious view of gearing and, while they recognise its advantages, prudently require five times cover and use this as a guide to the maximum amountof fixed interest debt they can incur.

Sources of finance

The main sources of finance available to a company are:
1. Short-term borrowing;
2. Medium-term finance;
3. Longer-term debt capital;
4. Convertibles;
5. Equity capital; and,
6. Venture capital.
Short-term borrowing

Short-term (less than one year) funds to finance current trading can be obtained by means of the following:
Trade credit.Delaying payment for goods received.
Short-term bank lending.Through self-liquidating loans or overdrafts. An overdraft or, in the USA, a line of credit facility, is relatively cheap and can be used flexibly. It is particularly useful for companies where the demand for and supply of cash fluctuate widely throughout the year.
Bill finance and acceptance credits.Where the borrower signs a promissory note or trade bill, issued by his or her creditor, for a stated term for repayment and an appropriate rate of interest. An acceptance credit allows theborrower to draw his or her bill directly on the bank and this bill can be rediscounted or sold in the market, thereby generating immediate cash. Trade or bank bills usually carry a modest interest rate.
Intercompany loans and the interbank market.Limited facilities exist in the UK for intercompany loans when companies bypass the banking system by placing deposits directly with one another or through a broker.
Factoring.A factor purchases his or her client's book debts and, on an agreed maturity date, pays to the client the full value of the approved debt purchased less the agreed service fee of between I and 3 per cent of turnover.

A HANDBOOK OF MANAGEMENT TECHNIQUESMichael Armstrong
Published by Excel Books
Price: Rs 595