Understanding Capital Gearing
Capital gearing refers to the ratio of a company’s debt to its equity. Also known as financial gearing or financial leverage, capital gearing serves as a financial metric to measure the proportion of a company’s capital that comes from borrowed funds in comparison to its own funds or equity. It indicates how a company is financed and how much it relies on debt to fund its operations and growth further helping investors, analysts, and shareholders understand the financial risk and growth potential of the company. Capital gearing ratios vary depending on the industry in which a company operates.
How to Calculate Gearing Ratio?
The gearing ratio calculates a company’s capital structure by showing how it is financed through debt (from creditors) compared to equity (from shareholders). The formula for calculating the capital gearing ratio is:
Capital Gearing Ratio= Shareholder’s Equity/ Capital with Fixed Costs
Types of Capital Gearing
High Gearing:
- When a company relies more on debt as compared to equity.
- A higher gearing ratio suggests that the company may struggle to fulfill future commitments to repay its debts if its business slows down. Similarly, investors might see companies with higher gearing ratios in cyclical industries as risky and more susceptible to economic fluctuations.
- However, companies with higher gearing ratios in stable industries may not be as alarming as it is in cyclical industries to lenders and investors and may lead to stable revenues due to their regulated rates.
- In some cases, companies deliberately increase their capital gearing to fund a leveraged buyout or to acquire another company.
Low Gearing:
- When a company relies on equity and has a lower debt-to-equity ratio.
- A lower gearing ratio Indicates lower financial risk because the company relies more on its own funds than on borrowed money.
- A lower gearing ratio provides financial stability and reduces risk however, it may in some cases limit favorable rewards.
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