Definition:-
Capital gearing is 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.
Capital gearing is also known as "financial leverage". It has to do with how a business engages in the process of financial leverage. Essentially, this approach focuses on how the company continues to remain solvent while acquiring new assets or diverting funds to support its general operations. This process of capital gearing addresses both debts that are created for the short-term, as well as long-term debt obligations.
Capital gearing is also known as "financial leverage". It has to do with how a business engages in the process of financial leverage. Essentially, this approach focuses on how the company continues to remain solvent while acquiring new assets or diverting funds to support its general operations. This process of capital gearing addresses both debts that are created for the short-term, as well as long-term debt obligations.
The process of capital gearing
It 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.
3. Make the idea is to 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.
4. Find 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.
5. Finally 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.
How Capital Gearing Works
- Consider what must occur when a company chooses to purchase a competitor.
- Here, 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.
- 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.
Notes:-The exact process of capital gearing varies from one business to another, as well as between industry types. A larger company may employ a different gearing strategy than a small business. In like manner, the approach used by a retailer may be very different from that of a manufacturer. Regardless of the size or type of business involved, the capital gearing strategy must be reevaluated from time to time, in order to keep the strategy in step with any changes that impact revenue streams, such as customer demand, the state of the economy, or shifts within the industry.
Mathematical Calculation for Capital Gearing
Gearing ratio is a general term that refers to several formulas and ratios that measure the amount of wealth that a business possesses as opposed to the money it owes to creditors. On a large scale, the ultimate gearing ratio is calculated by taking all of a company's borrowed money and dividing it into the amount of equity it holds, borrowings included. More specific ratios that fall under this blanket term include interest coverage ratio, debt/equity ratio, equity ratio, and debt ratio. All of these calculations are meant to judge a company's leverage, which is a measure of how much of its funding comes from outside sources as opposed to from the owners of the business.
Formula:
The formula/equation for the calculation of capital gearing ratio is as follows:
Capital gearing ratio = Equity / Fixed cost bearings securities
Where,
Equity = Equity share capital + Free reserves + Profits and loss account credit balance
Fixed cost bearing securities = Debentures + Long term loans
Significance:
Capital gearing must be carefully planned. Financial management gives us a concept of "Trading on Equity". It means as long as rate of earnings of business is higher than cost of fixed interest/dividend bearings securities the equity shareholders gain on the strength of their equity. Reverse follows in alternative situations.
Advantages of Capital Gearing
- Using gearing ratio to measure the amount of leverage is a solid way for investors to make decisions on the financial strength of a company.
- By comparing the different leverage ratios other companies in the same industry, a clear picture of that company's reliance on debt is achieved.
- The more volatile the business, the less a business should be leveraged. That's because businesses in such industries need to be able to weather highs and lows more readily.