Capital gearing

Capital gearing, also known as financial leverage or gearing ratio, is a financial metric that measures the proportion of a company’s capital that is financed by debt compared to equity. It provides insights into a company’s financial risk profile and its ability to meet its financial obligations.
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Updated on Jun 4, 2024
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3 Key Takeaways
Capital gearing measures the proportion of debt to equity in a company’s capital structure.
Higher gearing indicates a greater reliance on debt financing, which can amplify both profits and losses.
Understanding a company’s capital gearing is crucial for assessing its financial risk and making informed investment decisions.
What is Capital Gearing?
Capital gearing, also known as financial leverage, is a financial ratio that compares a company’s debt to its equity. It is a measure of a company’s financial risk, as a higher gearing ratio indicates a greater reliance on debt financing. This means that a company with high capital gearing has a larger proportion of its assets financed by debt compared to its own equity.

Importance of Capital Gearing
Financial Risk: Capital gearing is a key indicator of a company’s financial risk. High gearing can amplify profits during good times but can also lead to significant losses during economic downturns, as the company has to service its debt obligations regardless of its earnings.
Investment Decisions: Investors and analysts use capital gearing to assess a company’s financial stability and risk profile. Companies with high gearing may be perceived as riskier investments, while those with low gearing may be viewed as more stable.
Cost of Capital: Capital gearing can influence a company’s cost of capital, as lenders may demand higher interest rates for companies with higher gearing ratios due to the increased risk of default.
How Capital Gearing Works
Capital gearing can be calculated using various formulas, but the most common one is the debt-to-equity ratio:

Capital Gearing (Debt-to-Equity Ratio) = Total Debt / Total Equity
Total Debt: This includes all of the company’s borrowings, such as bank loans, bonds, and other debt instruments.
Total Equity: This represents the shareholders’ investment in the company, including share capital and retained earnings.
A higher debt-to-equity ratio indicates a higher level of gearing, while a lower ratio suggests a lower level of gearing.

Examples of Capital Gearing
A company with £1 million in debt and £2 million in equity has a capital gearing ratio of 0.5.
A company with £3 million in debt and £1 million in equity has a capital gearing ratio of 3.
A company with no debt has a capital gearing ratio of 0.
Real-World Application
Capital gearing is a crucial concept for investors and businesses alike. For investors, it helps assess the risk associated with investing in a particular company. For businesses, it is a tool for evaluating their financial structure and making decisions about capital allocation.

By understanding a company’s capital gearing, investors can make more informed decisions about whether to invest in the company and how much risk they are willing to take on. Businesses can use capital gearing to optimize their capital structure and ensure that they are not taking on excessive debt, which could jeopardize their financial stability.


Sources & references

Arti

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Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000 Invezz related data points, has read every piece of research, news and guidance we\'ve ever produced, and is trained to never make up new...