Notes On Capital Gearing:

Meaning Of Capital Gearing:

       Simply, the term "Capital Gearing" refers to the ratio between the various types of securities in the capital structure of the company.

       In the opinion of Grestenberg, "Capital gearing refers to the makeup of the firm's capitalisation." In other words, it represents mix of different sources of long term funds (equity shares, preference shares, long term loans, retained earnings etc) in the total capitalisation of the company.

       Gearing of capital may be either high or low depending upon the circumstances. When the proportion of equity shares to the total capitalisation is smaller than other securities, the capitalisation is said to be highly geared but when the proportion is greater, it is said to be low geared.

Form of Capital Gearing:

      The capital gearing of a company may take any of the form:

  1. Equity Shares only,
  2. Equity Shares and Preference Shares,
  3. Equity Shares and Debentures,
  4. Equity Shares, Preference Shares and Debentures.
Factors Influencing the Pattern of Capital Gearing:

       The capital gearing of a company depends upon a large number of factors. It is not possible to rank them as all such factors are of equal importance. The factors mainly influencing the capital structure of a company are as follows:

1. Growth and Stability of Sales:

       If the sales of the firm are expected to remain fairly stable, it can raise higher amount of debt. Stability of sales ensures that the firm will not face any difficulty in meeting its fixed requirements. On the contrary, if the sales are fluctuating, it should not opt for debt financing to the extent possible.

2. Cost of Capital:

       The cost of capital refers to the minimum rate of return expected by the supplier. The rate of return depends on the degree of risk involved. Compared to equity or preference shares, debt financing is cheaper because of fixed rate of interest on debt and priority payment in case of winding up. While formulating capital structure efforts must be made to minimize the cost of capital.

3. Cash Flow Ability to Service Debt:

       A firm should be able to generate large and stable cash inflow to employ more amount of debt in its structure. Debt financing implies burden of fixed charges due to the fixed payment of interest and the principle. Before raising additional funds, a firm should estimate, project its future cash inflow to ensure the coverage of fixed assets.

4. Nature and Size of the Firm:

       The nature and size of the firm also influence its capital structure. A public utility concern can employ more debt because of its stability of earnings. On the contrary, a concern which cannot provide stable earnings due to its nature of business should rely mainly on equity capital.

5. Control:

       Management should raise funds without any loss of control over the firm. Rising of funds through issue of shares will dilute the control of the existing share holders.

6. Flexibility:

       The capital structure of the firm should be flexible so that it may substitute one form of financing by another. Preference shares and debentures which can be redeemed at the discretion of the firm offer the highest flexibility in the capital structure.

7. Capital Market Condition:

       Bearing of Capital also depends upon the condition of the capital market. During depression, investors would prefer safety, so the company should issue debentures. While in case of boom, it would be advisable to issue shares.

8. Assets Structure:

       The liquidity and composition of assets of the organisation should also be considered while determining its capital structure. If fixed assets constitutes major portion of the total assets of the company, it may be possible for the company to raise more long term debts.

9. Purpose of Finance:

       For, productive purpose debt financing is suitable and the company should issue debentures as interest can be paid out of profits generated from the investment. Equity capital is preferable for unproductive or general development on permanent basis.

10. Period of Finance:

       The period for which the finances are required is also an important factor to be considered while selecting an appropriate capital structure. If the finances are needed for short period say 5 years, then debentures should be preferred and when are needed on permanent basis, equity shares stands appropriate.

Essentials of Sound Capital Gearing:

       A sound capital gearing should have the following essential features:

  1. Maximum possible use of leverage.
  2. Flexible capital structure.
  3. It should avoid undue financial or business risks with the increase of debt capital
  4. The use of debt should be within the capacity of the firm
  5. It must avoid undue restrictions in agreement of debt.