Shareholders ought to have the upper hand because if they don't that could cause them problems as follows:
- Shares earn dividends but in poor years dividends may be zero: that is, businesses don't always need to pay any!
- Long term liabilities are usually in the form of loans and they have to be paid interest; even in bad years the interest has to be paid
- Equity shareholders have the voting rights at general meetings and can made significant decisions
- Long term liability holders don't have any voting rights at general meetings but they have the power to override the wishes of the shareholders if there are severe problems over their interest or capital repayments
So, shareholders like to see the gearing ratio, the relationship between long term liabilities and capital employed, being in their favour! Let's look at the Carphone Warehouse's gearing ratio.
|Gearing||=||Long Term Liabilities|
|Equity Shareholders' Funds|
|Carphone Warehouse||31 March 2001||25 March 2000|
|Creditors: Amounts falling due after more than one year||14,107||21,033|
|Equity shareholders' funds||436,758||44,190|
|Gearing Ratio for the Carphone Warehouse|
|31 March 2001||14,107: 436,758||0.032: 1|
|25 March 2000||21,033: 44,190||0.476: 1|
A shareholder of the Carphone Warehouse will be happy with these results. Even in 2000 when the ratio was relatively high at 0.476 or 47.6% they probably were not too worried because their other ratios were fine too.
In 2001 the gearing ratio fell to almost zero indicating that the business much prefers equity funding to debt funding. This minimises the interest payment problems and the control problems of having a dangerously high level of long-term debt on the balance sheet.