Capital Gearing: Meaning and Significance

After reading this article you will learn about Capital Gearing:- 1. Meaning of Capital Gearing 2. Significance of Capital Gearing 3. Trade Cycles.

Meaning of Capital Gearing:

The term ‘capital gearing’ refers to the relationship between equity capital (equity shares plus reserves) and long-term debt. It may be planned or historical, the latter describing a state of affairs where the capital structure has evolved over a period of time, but not necessarily in the most advantageous way.

In simple words, capital gearing means the ratio between the various types of securities in the capital structure of the company.

A company is said to be in high-gear, when it has a proportionately higher/large issue of debentures and preference shares for raising the long-term resources, whereas low-gear stands for a proportionately large issue of equity shares.

The example given below illustrates clearly the terms ‘high gear’ and ‘low gear’:

Extracts of Balance Sheets

The total capitalisation of the above two companies is the same i.e. Rs. 10,00,000 for each company, but the capital structure differs. A Ltd. is high geared as the ratio of equity capital in the total capitalisation of the company is only 40%. But B. Ltd. is low geared as its capital structure comprises of 60% of equity capital and only 40% of the fixed cost bearing securities.

Significance of Capital Gearing:

The problem of capital gearing is very important in a company. It has a direct bearing on the divisible profits of a company and hence a proper capital gearing is very important for the smooth running of an enterprise.

In case of low geared company, the fixed cost of capital by way of fixed dividend on preference shares and interest on debentures is low and the equity shareholders may get a higher rate of dividend. Whereas, in a high geared company the fixed cost of capital is higher leaving lesser divisible profits for the equity shareholders.

The capital gearing in the financial structure of a business has been rightly compared with the gears of an automobile. The gears are used to maintain the desired speed and control. Initially, an automobile starts with a low gear, but as soon as it gets momentum, the low gear is changed to high gear to get better speed.

Similarly, a company may be started with high equity state, i.e. low gear but after momentum, it may be changed to high gear by mixing more of fixed interest bearing securities such as preference shares and debentures.

It may also be noted that capital gearing affects not only the shareholders but the debenture holders, creditors, financial institutions, the financial managers and others are also concerned with the capital gearing.

Capital Gearing and Trade Cycles:

The technique of capital gearing can be successfully employed by a company during various phases of trade cycles, i.e., during the conditions of inflation and deflation, to increase the rate of return to its owners (equity shareholders) and thereby increasing the value of their investments.

The effect of capital gearing during various phases of trade cycles is discussed below:

i. During Inflation or Boom Period:

A company should follow the policy of high gear during inflation or boom period as the profits of the company are higher and it can easily pay fixed costs of debentures and preferences shares.

Further, during boom period, the rate of earnings of the company is usually higher than the fixed rate of interest/dividend prevailing on debentures and preferences shares. By adopting the policy of high gear, a company can increase its earnings per share and thereby a higher rate of dividend.

ii. During Deflation or Depression Period:

During depression the rate of earnings of the company is lower than the rate of interest/dividend on fixed interest bearing securities and hence it cannot meet the fixed costs without lowering the divisible profits and rate of dividend. It is, therefore, better for a company to remain in low gear and not to resort to fixed interest bearing securities as source of finance during such period.

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