Capital gearing means maintaining the desired and proper proportions between various types of securities in the capital structure of the company.
In other words, deciding the ratio of capital to be made available by various sources, in total capitalization is known as capital gearing.
The term capital gearing is used to describe the ratio between the ordinary share capital and fixed interest-bearing securities of a company.
Thus, the relationship between equity share capital, preference share capital and debt capital is termed as capital gearing.
Types of Capital Gearing
Capital gearing is of following types:
1. High Gearing
When the amount of equity share capital in the company is less than the Debt capital and preference share capital, that situation is said to be high gearing.
In other words, when in any company ordinary share capital is less than other fixed interest-bearing securities, then it’s known as high gearing.
2. Low Gearing
When the amount of equity share capital is more than the amount of debt capital and preference share capital, then it is known as low gearing.
In other words, in the situation when the ratio of equity shares capital is more than fixed cost bearing securities, it is known as low gearing.
Types of Capital Used in Business
The capital used in business may be divided into the following three parts, from the view of capital gearing:
1. Fixed Cost Capital
The capital on which interest or dividends are paid at the fixed-rate, that is called fixed cost capital.
It includes preference shares and debentures.
2. Variable Cost Capital
It includes equity share capital and its cost is uncertain and variable.
The amount of dividend paid on its depends upon the policy of the directors and on the amount left out after reducing the returns on fixed cost bearing capital from the total income.
3. No Cost Capital
No cost capital includes all those capital inputs, which are used for the operation of the business, but on which no return are to be paid, like unpaid expenses, reserve funds, and business credit, etc.
Importance and Advantages of Capital Gearing
Following are the importance and advantages of capital gearing:
- By assessing capital gearing, any institution may obtain capital at the lowest costs.
- The financial position of the institution may be strengthened with the help of capital gearing and proper gearing of capital may be done for its efficient operation also.
- Any institution may determine the ratios of its capital sources through it, to make the best utilization of money.
- The balanced mix of various securities may be regulated, by it.
- Profit earning and fluctuations may be regulated, by it.
- It strengthens the qualitative aspect of the capital structure.
- Capital gearing provides a rational balance to the capital structure. As a result, the investor, creditors and enterprise, all get benefits.
- Capital risks may be reduced by capital gearing and profit earning capacity of the Institution may be increased.
Effects of Capital Gearing in Trade Cycles
The enterprise may be safeguarded against the ill effects of trade cycles boom and depression, by way of proper gearing. If the market has the conditions of depression, the profits of the enterprise become uncertain.
In such a situation, it is better to depend on equity capital alone, because by being less dependent on fixed cost capital, the management May saves the financial position of the enterprise, from being spoiled.
On the contrary, if the market has conditions of Boom, then the business earns a good profit.
Hence, fixed cost capital (preference shares and debentures) may be increased.
As a result, the shareholders may also be benefited from higher profits, which will also raise the Goodwill and reputation of the company.
Hence, it is clear that successful financial managers should go on changing capital gearing of his business/company/institution, according to the movements of trade cycles, to save the enterprise from the ill effects of business boom and depression.
Steps for Fulfill Financial Requirements of Business
In the beginning, when an enterprise is established, Two Steps should be taken to fulfill its financial requirements:
- To issue securities with variable costs.
- To collect capital in the beginning by equity shares.
However, as the enterprise progresses and certainty of income goes on increasing fixed cost capital may be increased.
This process is known as capital gearing.
It is evident that in a business like – vehicle, gears function in a car. As the car is not taken in the highest gear, when it is started, Similarly, in business high gear may not be used at the initial stage.
Hence, while starting the business, the management should keep more of equity capital, like, the low gearing of capital should be exercised.
But, as the business-like vehicle goes on catching speed, it should be brought in high gearing like the car, meaning thereby that debt capitals should be increased with pace and expansion of the business.
As a result, the ratio of fixed capital cost bearing capital will be higher than the equity capital.
Thus, now you know the ultimate guide to capital gearing.