Lower Bankruptcy Risk

• The main benefit of a conservative capital structure is low bankruptcy risk. If a company experiences a difficult few years, and revenue has been low or negative, it may not be adequate to pay interest payments on long-term debt. If there are insufficient cash reserves to make these payments, the company may go bankrupt. The higher the proportion of long-term debt, the greater the interest payments that need to be made. In contrast to debt payments, dividend payments for shares are at the discretion of the company itself. Some companies that engaged in leveraged buyouts in the 1980s went bankrupt because they were too highly geared.
  
  

Increased Financial Flexibility

• Another benefit of a low gearing ratio is increased financial flexibility. For example, a company may choose to sacrifice short-term profits for greater long-term profits by investing in products or production processes that will not generate short-term profits. However, if a company is highly geared, it must retain a certain level of income to make its debt payments.
  
  

One Drawback: Taxation

• One benefit of greater leverage is the presence of a so-called tax shield. This arises because equity payments are made out of profits -- which are subject to corporation tax -- whereas debt payments are an expense deducted before taxation. Since investors will require similar risk-adjusted rates of return for debt and equity, it will be cheaper for a company to raise finance through debt.
  
  

Highly Geared Companies

• Generally, a gearing ratio of above 50 percent indicates that a company is highly geared. Beyond this point, the business model may be perceived to be excessively risky, although this will not always be the case. A conservative capital structure should be below 50 percent.