However, debt finance is relatively cheap to companies, partly because the lenders of that finance face little risk (they have to be paid a fixed return and they have security), and partly because interest payments reduce taxable profits. Conversely, share capital finance is expensive because dividend payments have to be high to compensate for their variability and uncertainty, and the shareholders lack of security. They also have to be paid from after tax profits. Some companies have certain classes of shares (preference shares) which offer a fixed dividend payout which has to be paid before ordinary shareholders can appropriate the remaining profits. In some ways they are like debt as they require a fixed payment and require a lower return than ordinary shareholders (because their return is more certain), but it is normally possible, when the company is making losses, for directors to defer or waive the preference dividend, so there is some flexibility in desperate circumstances.

Like ordinary share dividends, preference dividends can only be paid from profits (current or retained).

Operational gearing

A similar idea applies to the variability of profits as a result of changes in sales turnover (a measure of overall company activity). Where a company is committed to paying a large proportion of its costs regardless of trading conditions (due to large specialist machinery investments, or ongoing research and development programmes, or a large salaried workforce) its profits will be much more variable than one that has costs which tend to vary with sales turnover (little specialist machinery, little technology investment, casual workers). The idea of operational gearing and 'fixed' and 'variable' costs will be analysed in more detail in the Management Accounting section as 'break-even' or 'cost-volume-profit' analysis.