Capital Gearing

The ratio indicates the financial risk to which a business is subjected, since excessive debt
can lead to financial difficulties. A high gearing ratio represents a high proportion of debt to
equity, while a low gearing ratio represents a low proportion of debt to equity.

Fixed Interest Bearing Funds

Capital Gearing =
Common Shareholders Equity

Common Shareholder Equity = Share Capital + Reserve & Surplus

CGR >1 There is very high financial (Solvency) Risk

CGR 0.5 – 1 high financial (Solvency) Risk

Trading on Equity

Trading on equity occurs when a company incurs new debt (such as from bonds, loans,
or preferred stock) to acquire assets on which it can earn a return greater than the interest cost
of the debt. If a company generates a profit through this financing technique,
its shareholders earn a greater return on their investments. In this case, trading on equity is
successful. If the company earns less from the acquired assets than the cost of the debt, its
shareholders earn a reduced return because of this activity. Many companies use trading on
equity rather than acquiring more equity capital, in an attempt to improve their earnings per
share.

Trading on equity – also known as financial leverage – is considered successful if the

company generates a profit and a higher return on investment for the shareholders.
Companies, usually, go for trading on equity (instead of raising capital via issue for shares) to
improve their earnings per share (EPS).