earing in Relation to Financial
Risk
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The term ‘gearing in a financial context refers to the amount of debt
finance a company uses relative to its equity finance. A company
with high level of debt component in its capital structure is said to
be ‘highly geared and vice versa. The gearing of a company can be
calculated with the help of financial ratios like debt-equity ratio
(long-term debt / shareholders’ funds), capital gearing ratio (long-
term debt/capital employed).
The problems associated with a high level of gearing are as
follows:
(a) The profitability and earnings are more sensitive due to changes
in interest rates of different debt components.
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(b) Highly geared company is subject to higher financial risk.
(c) There is an increased possibility of bankruptcy risk with high
levels of debt in capital structure.
(d) The stock market prices of equity shares of a company will be
quoted less if it is highly geared due to high levels of financial and
bankruptcy risk.
(e) The long-term planning will be sidelined due to increased
pressure of raising cashflow for meeting the interest and principal
amounts repayment.
The optimum level of gearing depends upon the requirements of the
industry in which a particular company is operating. The interest
cover is considered as ratio to ascertain the level of income gearing.
While calculation of capital gearing ratio, market values of debt and
equity are considered to be more appropriate than book values.
The firm with low business risk can be able to carry high levels of
gearing, since its stability can enable the firm to withstand to high
levels of financial risk. In the initial stages of financing with lower
levels of debt, the firm’s distributable profits are reduced by the
interest payments. Due to tax shield, the net interest payments (i.e.,
Interest on debt minus tax saving due to interest charge against
profits) will enable the firm to trade on equity.
In other words, the earning of return on investment over fixed
interest on debt less tax savings, will add up to the profits available
to equity holders. The volatility in operating profits will increase
financial risk due to firm’s obligation to pay interest and repayment
of debt in time.
Therefore, higher levels of gearing cause higher levels of financial
risk. If the level of gearing increases, the expected return of equity
shareholders will also increase, along with the increase in financial
risk and bankruptcy risk due to higher levels of debt component in
total capital and the expectation will be more to compensate for
taking higher levels of financial and bankruptcy risk.
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Gearing and Cost of Capital:
Empirical evidence shows that over a wide range gearing, the
proportion of debt has relatively little impact on the cost of capital.
This is explained in the following illustration: (%)
The above data is represented in figure 28.3. So long as the existing
gearing of the company is within the optimum range say 30% to
60%, the proportion of debt in a company’s capital structure has
little effect on a company’s cost of capital. A company can operate
within this range to maintain the unaffected cost of capital.
Gearing and EPS:
In capital structure decisions, the impact of gearing ratio is viewed
on earnings per share. The amount of gearing has considerable
effect on the earnings attributable to the equity shareholders. A
highly geared firm must earn enough profits to cover the interest on
debt before any profits available for distribution to the equity
holders.
ABC Ltd. is setting a project with a cost of Rs. 50,00,000. It is
considering the following three alternatives for financing
