An Understanding Of Capital Gearing & Trading On Equity

“After heavy financial crunches in the economic system, for a corporate entity, it’s fairly vital to have a perfect mix of assorted capital sources to make sure good returns and overcome from the depth of losses.”

Here, some crucial phrases have been defined close to the monetary system of an organization:

CAPITAL STRUCTURE

The types of securities to be issued and proportionate quantities that make up the capitalization is named capital structure or financial structure.

Capital construction refers to the proportion of various kinds of securities issued by an organization to boost lengthy-time period finance. Thus capital construction denotes: (1) the types of securities issued (equity shares, desire shares and debentures), and (ii) the relative proportion of each type of security. In other words, capital construction represents the proportion of equity capital and dept capital used for financing the operations of a business. Proper balance must be obtained in the following securities or sources of finance to maximize the wealth of the equity shareholders of the corporate:

(a) equality shares,

(b) choice shares, and

(c) debentures

Options of Sound Capital Structure

An organization’s capital construction is alleged to be optimum when the proportion of debt and equity is such that it leads to maximizing the return for the equity shareholders. Such a structure would differ from firm to firm relying upon the nature and size of operations, availability of funds from different sources, efficiency of administration, etc.

A SOUND CAPITAL STRUCTURE SHOULD POSSESS THE FOLLOWING FEATURES:

(i) MAXIMUM RETURNS.

(ii) LESS RISKY.

(iii) FLEXIBILITY

(iv) ECONOMY.

(v) DYNAMIC.

FINANCIAL LEVERAGE OR CAPITAL GEARING

A company can increase capital by issuing three types of securities: (a) equity shares, (b) desire shares, and (c) debentures. Choice shares carry a fixed rate of dividend and debentures carry a fixed rate of interest. The equity shares are paid dividend out of earnings left after cost of interest on debentures, and dividend on preference shares. Thus, dividend on equity shares could vary year after year. Equity shares are often known as variable return securities and debentures and desire shares as fixed return securities. If the rate of return on fixed return securities is lower than the rate of earnings of the company, the return on equity shares will be higher. This phenomenon is named monetary leverage or Physician Capital gearing.

Thus, financial leverage is an arrangement below which fixed return bearing securities (debentures and choice shares) are used to raise cheaper funds to extend the return to equity shareholders. It could be noted that a lever is used to lift something heavy by applying less force than required otherwise.

Capital gearing denotes the ratio between varied types of securities and total capitalisation. Capitalisation of an organization is highly geared when the proportion of equity to total capitalization is small and it’s low geared when the equity capital dominates the capital structure.