Capital Gearing and It’s Significance

Definition of Capital Gearing

The most important factor which must be taken into account by the promoters while drafting the financial plan of a company is capital gearing.

Gearing means the ration of different types of securities to total capitalization. The term, when applied to the capital of a company, means the ratio of equity share capital to the total capital and is known as capital gear ratio or capital gearing.

J. Batty defines the term ‘capital gearing’ as “The relation of ordinary shares (equity shares) to preference share capital and loan capital is described as the capital gearing.”

Thus the term 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 earnings and undistributed profits.

High and low Capital Gearing

If the proportion of equity capital to the total capital is small or in other words the ration of other fixed cost capital to total capital is high, it is said to be a state of high gearing of capital. Reverse is the case of low gearing of capital i.e., low proportion of equity capital or high proportion of fixed cost capital to the total capital is an indication of low gearing of capital.

A company with low gearing is one that is mainly being funded or financed by equity capital and reserves, whilst the one with a high gearing is mainly funded by debt capital.

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.

In 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.

The problem of capital gearing is very important from the financial manager’s point of view. He must know, in what securities should the funds for the company be raised and in what proportion ? It is very important for the success of the company. All concerning parties, i.e., shareholders, debenture holders, creditors an the concern itself are affected by it. A low geared company can pay more dividend to its shareholders or a high-geared company also can pay higher dividend to its shareholders in inflationary conditions of the market if proper capital gearing is maintained.

Bookmark the permalink.