After reading this article you will learn about the concept of capital gearing and factors affecting it.
Concept of Capital Gearing:
Assume that a company can issue three types of securities, i.e., equity shares, preference shares and debentures. But what should be the proportion of these securities. For this purpose, we shall study Capital Gearing. Capital Gearing determines the ratio between the various types of securities to the total capitalisation.
Capital gearing may be determined by ascertaining the ratio between the amount of equity capital (representing variable income bearing securities) and the total amount of securities (equity shares, preference shares and debentures) issued by the company.
As an example, if two companies, each having issued the total securities worth Rs. 10.00,000 have equity shares of Rs. 2,00,000 and Rs. 8,00,000 respectively, the first company is highly geared as the ratio between equity capital and total capitalisation is small i.e., 20%. But in the case of 2nd company, this ratio is 8,00,000/10,00,000 i.e., 80%, so it is low geared.
The higher the capital gearing of a company, the more speculative will be its equity shares. The equity shareholders may either get higher dividend or no dividend. If a large amount of profit is left after paying interest to debenture holders and dividend to preference shareholders, it can be distributed among the equity shareholders.
Such a situation will increase the prices of shares in the stock exchange. On the other hand, it may also happen that no profit is left after paying the debenture holders and preference shareholders.
Factors Affecting Capital Gearing:
The following factors are considered while determining the ratio of different securities:
(1) Trading on Equity,
(2) Control of business,
(3) Flexibility of financial plan (Refer article for details),
(4) Choice of investors,
(5) Cost of raising finance, and
(6) Capital market conditions.
If market is running under depression, people do not want to take risk and so are not interested in equity shares. Debentures and preference shares which carry a fixed rate of return can be marketed more easily during depression.
It should, however, be noted that business control is centered in the hands of equity shareholders who have the voting right in the general body meeting to control the management of the company. Preference shareholders, if at all, possess very limited right of voting and debenture-holders have no right of voting.