Capital Gearing

Published Apr 6, 2024

Definition of Capital Gearing

Capital Gearing, also known as financial leverage or capital structure, refers to the ratio between various types of securities and capital used by a company to finance its overall operations and growth. In essence, it points to the balance between equity (shares owned by shareholders) and debt (loans) in a company’s capital structure. A company with high capital gearing has a greater proportion of debt compared to equity, while low capital gearing indicates a larger equity base relative to debt.

Example

To illustrate, consider Company XYZ, which primarily funds its operations and expansion projects through issuing shares to the public and retained earnings, with minimal reliance on borrowing loans. This company would have low capital gearing since it relies more on equity than on debt. Conversely, Company ABC, which has taken significant loans to finance its rapid expansion, while having less equity, is considered to have high capital gearing.

The choice between high and low capital gearing depends on various factors, including the cost of borrowing (interest rates), tax considerations (interest is tax-deductible), and the degree of financial risk the company is willing to undertake. High capital gearing increases the potential returns to equity shareholders but also comes with higher financial risk, especially in times of economic downturns or increased interest rates.

Why Capital Gearing Matters

Capital Gearing is a crucial aspect of a company’s financial strategy and management because it impacts the company’s risk profile and return on equity. High gearing denotes a risky position: it implies that a company has to ensure enough earnings to cover the interest payments before any profit is realized, which can be particularly challenging during economic downturns. On the other hand, low gearing indicates a conservative approach, potentially resulting in lower returns to shareholders but offering more stability during economic fluctuations.

Investors and financial analysts closely monitor a company’s capital gearing ratio as part of their investment decision-making process. A high capital gearing ratio can make a company’s shares less attractive to risk-averse investors, while a low ratio can appeal to those seeking safer investment opportunities.

Frequently Asked Questions (FAQ)

How is capital gearing calculated?

Capital gearing ratio can be calculated by dividing a company’s debt by its equity. There are variations in formula, potentially including long-term debt only or total debt in the numerator and sometimes incorporating shareholder equity plus reserves in the denominator. The specific metrics used can vary depending on the analysis’s purpose or the industry standard.

What impacts does a change in capital gearing have on a company?

Changes in capital gearing can significantly impact a company’s return on equity and overall financial health. Increasing debt (thereby increasing capital gearing) may lead to higher returns on equity as long as the company earns more on its investments than the interest rate on its debt. However, this also increases the financial risk, as the company must meet its debt obligations irrespective of its financial performance. Conversely, decreasing debt moves the company towards a more stable, but potentially less lucrative, financial structure.

How do companies decide on their capital gearing level?

Deciding on the appropriate level of capital gearing involves balancing the benefits of leverage against the costs and risks of debt. Factors influencing this decision include the cost of debt, the volatility of the company’s earnings, the stage of the company in its lifecycle (startup vs. mature), tax considerations, and the industry benchmark. Companies might adopt a high-gearing strategy to exploit growth opportunities when borrowing costs are low, or opt for low gearing to maintain financial flexibility and stability.

Can a company have too low capital gearing?

Yes, a company can have too low capital gearing, which might suggest that it’s not effectively leveraging the potential benefits of debt financing. This conservative approach can lead to lower returns on equity, as the company may be missing out on profitable investment opportunities by not taking advantage of the typically lower cost of debt compared to equity financing. However, the optimal capital gearing ratio varies widely among industries and individual company strategies.