Capital gearing

Capital gearing is an indicator describing the indebtedness of an enterprise in relation to its equity. It is also known as leverage (in the US).

Commitments that are borne by the company usually have to be made with interest. Of course, these costs will apply to bank loans or loans. The financial leverage informs about whether the debt service burden is not too high and has no negative impact on the company's profitability. Its level determines the profitability of using foreign capital (e.g. loans).

The financing of foreign capital is aimed at improving profitability and increasing management efficiency. Such financing makes sense until the return on equity is higher. The leverage ratio is used to determine the correctness of the level of debt. A high level of leverage informs that the company may have liquidity problems in the future, activity slows down, capital investment is required and means higher investment risk. Capital gearing also increases dramatically when the company performs buyout.

It should be noted that the leverage has various typical values depending on the industry and type of company. Therefore, when comparing different companies, this should be taken into account.

Capital Lever (Financial)

• To increase the profitability of our equity, we must use foreign capital.
• Leverage will work if liabilities are higher than the rate of interest paid.
• equity is not interest-bearing, which is why it is necessary to take into account the fact that the cost of external capital decreases the basis for the income tax dimension, i.e. it increases the costs of obtaining income.
• profitability adjustment of property includes interest on foreign capital that is already paid and tax at the applicable rate, which is calculated on interest paid already.

It is defined as the level of total credit costs, comparing them to the effectiveness of using own resources. This tool answers the question of whether or not to take out a loan. For example, if we achieve low efficiency from our own funds, it may be likely that we will not pay the loan costs. However, when we achieve high efficiency on our own assets, at the time of collecting the loan, we will achieve through capital supply, additional profits. This is the goal of financial leverage.

Adjusted profitability of assets = net profit + interest - total tax / property

Profitability of assets = Net profit / total assets.

Financial leverage = profitability of own capitals - adjusted value of assets.

If it is a positive value, it means that leverage has worked. A positive effect will occur then, the profitability of the whole enterprise capital will be higher than the interest rate on foreign capital.

EBIT / foreign capital * 100%> ik

Otherwise, the profit generated by the foreign part of the capital will be lower on interest due which will absorb part of the profit generated by equity.

Operational leverage

Operational leverage is related to costs in the enterprise and allows to measure the relationship between net revenues from sales and operating profit. There is a scale of flexibility between these variables. The profits we achieve are related to the planned level of sales, but are not proportionate with each other. With the manufacturing capabilities of the enterprise, there is a constant level of fixed costs, the higher it is the higher the differences between the increase in sales and the profit that accompanies the increase. These changes are to present operational leverage and its scope can be presented by means of a modified profit and loss account. The leverage effect can be positive or negative, it depends on the effects caused by a change in production or sales. A higher level of utilization of production capacities may result in a reduction of fixed costs, which results in a higher change in profit depending on the pace of changes in sales.

The total leverage is the product of financial and operational leverage, which we use to determine the degree of financial and operational danger. It combines a change in net income from the forex, operating profit, net profit and return on equity.

Examples of Capital gearing

• Debt-to-Equity Ratio (D/E): This ratio measures the amount of debt a business has compared to its equity and is calculated by dividing total liabilities by total equity. A higher D/E ratio indicates that the company is more highly leveraged and may be taking on more risk.
• Interest Coverage Ratio (ICR): This ratio measures a company's ability to cover its interest expenses with its operating income. It is calculated by dividing operating income by interest expense. A higher ICR ratio indicates that the company is better able to cover its interest expenses.
• Debt-to-Assets Ratio (D/A): This ratio measures the amount of debt a business has compared to its total assets and is calculated by dividing total liabilities by total assets. A higher D/A ratio indicates that the company is more highly leveraged and may be taking on more risk.
• Debt-to-Capital Ratio (D/C): This ratio measures the amount of debt a business has compared to its total capital and is calculated by dividing total liabilities by total capital. A higher D/C ratio indicates that the company is more highly leveraged and may be taking on more risk.

Advantages of Capital gearing

Capital gearing offers a number of advantages for businesses, including:

• Increased buying power: Capital gearing increases a business’s ability to acquire resources, such as property, buildings, and equipment, without needing to use their own capital. This can help businesses expand and grow without needing to invest large amounts of money up front.
• Lower cost of capital: By borrowing money, businesses can often access a lower cost of capital than they would be able to when using their own funds. This can help businesses save on interest payments and can leave more money to be used for other purposes.
• Ability to take advantage of opportunities: By having access to additional funds, businesses can take advantage of opportunities that they might otherwise not have been able to. For example, they may be able to take advantage of investment opportunities or to quickly expand into new markets.
• Increased liquidity: By having access to borrowed funds, businesses can ensure that they have enough liquidity to meet their short-term needs. This can help them maintain a positive cash flow and can help them remain competitive.

Limitations of Capital gearing

• Capital gearing does not measure a company’s overall financial health, as it does not take into account the company’s cash flow or profitability.
• It does not reflect the company’s ability to pay its debts and other liabilities, as it does not take into account the company’s ability to generate cash from its operations.
• It does not take into account the different types of debt a company has, such as secured and unsecured debt.
• It does not reflect the potential risks involved in taking on more debt, such as higher interest rates and increased financial volatility.
• It does not consider the company’s equity structure, nor does it factor in the impact of any changes in the company’s capital structure.
• It does not provide an indication of the company’s ability to raise funds in the future, as it does not take into account the company’s future prospects.
• It does not provide an indication of the company’s ability to withstand a recession or other economic downturns, as it does not take into account the company’s liquidity or cash flow.

Other approaches related to Capital gearing

• Debt to Equity Ratio: This is a measure of a company’s financial leverage calculated by dividing its total liabilities by stockholders’ equity. It indicates the proportion of equity and debt the company is using to finance its assets.
• Interest Coverage Ratio: This is a measure of a company’s ability to pay its interest expenses on outstanding debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses for a given period.
• Debt Service Coverage Ratio (DSCR): This is a measure of a company’s ability to meet its debt obligations. It is calculated by dividing a company’s cash flow available for debt service (cash flow before interest and principal payments) by its total debt service obligations.
• Debt Ratio: This is a measure of a company’s financial leverage calculated by dividing its total debt by its total assets. It indicates the proportion of assets that are financed by debt.

In summary, capital gearing is an indicator describing the indebtedness of an enterprise in relation to its equity, and other approaches related to it include debt to equity ratio, interest coverage ratio, debt service coverage ratio, and debt ratio.

Capital gearing — recommended articles

Debt management ratio — Solvency ratios — Borrowing capacity — Ebitda ratio — Degree of financial leverage — Asset coverage ratio — Cash Flow-to-Debt Ratio — Appropriation of retained earnings — Non current liability

References

• Brierley P., O. (2005). The Determination of UK Corporate Capital GearingBank of England Quarterly Bulletin.
• Eswar S. Prasad, Raghuram G. Rajan, Arvind Subramanian, N. (2007). Foreign Capital and Economic GrowthNBER Working Paper No. 13619.
• Hossain, M. M., & Ahmad, A. (2015). Is Buying Back of Shares a Dangerous Financial Strategy?. Global Journal of Management And Business Research.

Footnotes

Author: Izabela Palonek