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What is Capital Gearing?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 25 August 2016
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Capital gearing has to do with how a business engages in the process of financial leverage. Essentially, this approach focuses on how the company continues to remain solvent while acquiring new assets or diverting funds to support its general operations. This process addresses both debt that is created for the short-term, as well as long-term debt obligations.

The process of capital gearing involves the application of several common financial calculations. First, the company must undergo risk analysis, to determine what type of impact a specific action will have on the overall stability of the business. The idea is to make sure that even if the proposed action does not yield the anticipated return, it will still not undermine the existing operation, at least not to the point that the operation must close. The current relationship between what the company owes and the amount of revenue it generates is also important, especially when dividends must be paid to investors. Thus, calculating the current debt/equity ratio is also important to the process of capital gearing, as it aids in planning strategies for using assets to best advantage.

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One of the ways to understand how this process works is to consider what must occur when a company chooses to purchase a competitor. Here, the buyer must look at the cost of the acquisition, including ancillary factors like legal fees, or the settlement of debts owed by the business that is acquired. This cost must be compared to the amount of return that the buyer hopes to achieve from the transaction, including how long it will take to retire any debt incurred in order to make the purchase. By determining both the short-term and the long-term outcomes of the action, and its impact on the ability of the company to retire any new debt associated with the purchase, the business can then develop a capital gearing approach that will allow it to move forward without endangering any existing operations.

The exact process of capital gearing varies from one business to another, as well as between industry types. A larger company may employ a different gearing strategy than a small business. In like manner, the approach used by a retailer may be very different from that of a manufacturer. Regardless of the size or type of business involved, the capital gearing strategy must be reevaluated from time to time, in order to keep the strategy in step with any changes that impact revenue streams, such as customer demand, the state of the economy, or shifts within the industry.

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