Question 2.RQ.4: Distinguish between financial gearing and operating gearing....
Distinguish between financial gearing and operating gearing. Why do businesses often avoid having high levels of both financial and operating gearing?
Financial gearing arises from the presence of fixed return capital, such as borrowing, within the capital structure of a business. Operating gearing arises as a result of the presence of fixed operating costs within the cost structure of a business. Both types of gearing involve financial commitments. Financial gearing involves a commitment to pay interest charges and to make capital repayments when due. Operating gearing involves a commitment to pay fixed costs. These commitments must be met irrespective of the profits generated by the business. Furthermore, both types of gearing increase the sensitivity of returns. Financial gearing increases the sensitivity of returns to ordinary shareholders from changes in operating profits. Operating gearing increases the sensitivity of operating profits from changes in sales output. Thus, a business with a high degree of financial gearing and a high degree of operating gearing will have returns to ordinary shareholders that are highly sensitive to changes in sales output. This can increase the volatility of returns to shareholders and, as a consequence, the volatility of share prices. Many businesses, therefore, avoid combining high levels of financial and operating gearing.