Which one of the following statements about gearing is correct?
A)Investment in a low geared company is usually seen as relatively risky for ordinary shareholders.
B)An increase in a company's level of gearing invariably means that returns to shareholders are reduced.
C)A high level of gearing in a company gives rise to a high interest cover ratio.
D)Returns to shareholders in a highly geared company are likely to be more volatile than in a low geared company.

Question

Quizplus · Accepted Answer

A highly geared company has a lot of debt, which means they have to make regular interest payments. If the company experiences a downturn, it may struggle to make those payments and may have to cut dividends to shareholders. As a result, returns to shareholders in a highly geared company are likely to be more volatile than in a low geared company. Option A is incorrect as investment in a low geared company is seen as relatively safe for ordinary shareholders. Option B is also incorrect as an increase in gearing does not necessarily mean reduced returns. Option C is incorrect as a high level of gearing in a company gives rise to a low interest cover ratio, which means the company has less ability to pay its interest expenses.

Which One of the Following Statements About Gearing Is Correct