Gearing, or leverage, describes the mix of long-term corporate funding provided internally (by shareholders) to that contributed externally (by lenders).
Capital gearing' is used to indicate the relative proportion of fixed cost bearing securities such as preference shares and debentures to the ordinary share capital in the capital structure. Interest of equity share holders is represented by the amount of share capital plus retained earrings and undistributed profits. The degree to which a company acquires assets or to which it funds its ongoing operations with long- or short-term debt. Capital gearing will differ between companies and industries, and will often change over time.
Types Of Capital Gearing
1. Low-Geared
2. High-Geared
The ration of fixed interest loan and preference shares to the ordinary share capital of a company. A company in which the ordinary share capital is greater than its loan funds is called low-geared, while the opposite kind is called high-geared. The ordinary shares of a company are called equity; hence capital gearing is also known as equity gearing.
Process Of Capital Gearing
The process of capital gearing involves the application of several common financial calculations.
1. First, the company must undergo risk analysis,
2. Determine what type of impact a specific action will have on the overall stability of the business. The idea is to make sure that even if the proposed action does not yield the anticipated return, it will still not undermine the existing operation, at least not to the point that the operation must close.
3. The current relationship between what the company owes and the amount of revenue it generates is also important, especially when dividends must be paid to investors.
4. calculating the current debt/equity ratio is also important to the process of capital gearing, as it aids in planning strategies for using assets to best advantage.
5. focuses on how the company continues to remain solvent while acquiring new assets or diverting funds to support its general operations.
6. capital gearing addresses both debt that is created for the short-term, as well as long-term debt obligations.
7. the buyer must look at the cost of the acquisition, including ancillary factors like legal fees, or the settlement of debts owed by the business that is acquired. This cost must be compared to the amount of return that the buyer hopes to achieve from the transaction, including how long it will take to retire any debt incurred in order to make the purchase.
8. By determining both the short-term and the long-term outcomes of the action, and its impact on the ability of the company to retire any new debt associated with the purchase, the business can then develop a capital gearing approach that will allow it to move forward without endangering any existing operations.
Factors affecting the level of gearing :-
1. Employed by a company Before gearing ratios can be properly understood, it is instructive to analyse the factors
2. Sales and profits — companies that have a stable or growing rate of sales and profits are in a better position to finance the interest charges and capital repayments than those with volatile or declining rates of sales. Higher profits make it feasible to sustain higher levels of gearing.
3. Interest costs— if the company is perceived as being risky, for whatever reason, lenders are likely to demand higher returns to compensate for the risks involved. Where a very high rate of interest is demanded, the costs become prohibitive and effectively place a ceiling on the amount borrowed.
4. Cash flow — the need to service financial obligations (interest payments and repayment of the amount borrowed) render a strong, reliable cash flow necessary.
5. Borrowing restrictions — companies may have restrictions placed upon them regarding the amount of debt that can be raised (loan covenants). These may form part of the company’s articles of association, or may be stipulated in the terms of earlier loan agreements.
6. Industry norms — lenders will assess ‘norms’ for the particular industry before advancing funds. Companies in highly volatile industries would be expected to have lower gearing than those in more stable sectors.
7. Security — companies wishing to raise debt finance usually have to offer some kind of security (collateral) to the lender. Lenders will normally require good quality assets (ones that will not depreciate in value) as security. If such assets are not available, or are already secured, it may not be possible for a company to borrow additional funds.
8. Attitudes of key stakeholders — with day-to-day control in their hands, it is managers who will normally determine the level of gearing a company adopts. However, the attitudes of owners (particularly towards the financial risk associated with gearing) and lenders (who are concerned with security, cashflow of the company and its future prospects), must be considered.
9. Availability of equity funding— companies unable to secure additional funding from their owners may be forced to borrow to fund expansion.
Significance of Capital Gearing
A proper capital gearing is very important for the smooth running of the enterprise It affects the profitability of the concern.
n a low geared company, the fixed cost of capital will be lower and the equity shareholders will get a higher profit by way of dividend and in case of high gearing the fixed cost of capital will be higher and the profits to be distributed to the equity shareholders will be lower.
The role of capital gearing in a business is as important as gears in an automobile. In an automobile, gears are used to maintain the desired speed. Initially, an automobile starts with a low gear, and as soon as it gets momentum, the low gear is changed to high gear. Similarly, a business is started with a low gear, i.e, high proportion of equity capital and as soon as, the business gets momentum, it may subsequently issue fixed cost securities, i.e., preference shares and/or debentures. Thus the process of capital gearing deals with the makes up of capitalization.