Capital gearing ratio

Capital gearing ratio is a useful tool to analyze the capital structure of a company and is computed by dividing the common stockholders’ equity by fixed interest or dividend bearing funds.

Analyzing capital structure means measuring the relationship between the funds provided by common stockholders and the funds provided by those who receive a periodic interest or dividend at a fixed rate.

A company is said to be low geared if the larger portion of the capital is composed of common stockholders’ equity. On the other hand, the company is said to be highly geared if the larger portion of the capital is composed of fixed interest/dividend bearing funds.

Formula:

capital-gearing-ratio-img1

In the above formula, the numerator consists of common stockholders’ equity that is equal to total stockholders’ equity less preferred stock and the denominator consists of fixed interest or dividend bearing funds that usually include long term loans, bonds, debentures and preferred stock etc.

All the information required to compute capital gearing ratio is available from the balance sheet.

Example:

The following information have been taken from the balance sheet of PQR limited:

Year 2011:

Common stockholders’ equity: $3,500,000

Preferred stock – 9%: $1,400,000

Bonds payable – 6%: $1,600,000

Year 2012:

Common stockholders’ equity: $2,800,000

Preferred stock – 9%: $1,800,000

Bonds payable – 6%: $1,400,000

We can compute the capital gearing ratio for the years 2011 and 2012 from the above information as follows:

For the year 2011:

Capital gearing ratio = 3,500,000 / 3,000,000

= 7  :  6 (Low geared)

For the year 2012:

Capital gearing ratio = 2,800,000 / 3,200,000

= 7 : 8 (Highly geared)

The company has a low geared capital structure in 2011 and highly geared capital structure in 2012.

Notice that the gearing is inverse to the common stockholders’ equity.

  • Highly geared >>> Less common stockholders’ equity
  • Low geared >>> More common stockholders’ equity

Significance and interpretation:

Capital gearing ratio is the measure of capital structure analysis and financial strength of the company and is of great importance for actual and potential investors.

Borrowing is a cheap source of funds for many companies but a highly geared company is considered a risky investment by the potential investors because such a company has to pay more interest on loans and dividend on preferred stock and, therefore, may have to face problems in maintaining a good level of dividend for common stockholders during the period of low profits.

Banks and other financial institutions reluctant to give loans to companies that are already highly geared.

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17 Comments on Capital gearing ratio

  1. Fillimon Misha

    This is good and straight forward. Thanks

  2. Muhammad Mutahhar

    I did not got how gearing is inverse ratio to the common stockholders’ equity when increase in equity will result in increase in gearing???

  3. Accounting For Management

    Think about the capital structure of the company not the ratio figure. Highly geared capital structured means a capital structure composed of a large portion of fixed interest or dividend bearing funds. Gearing is inverse to the common stockholders equity because any increase in common stockholders’ equity will decrease the portion of fixed interest and dividend bearing funds and vice versa.

    In the above example 7:6 or 1.167 means the company has a low geared capital structure. A decrease in ratio figure, for example 7:8 or 0.875, means the company has a highly geared capital structure.

    Hope this helps.

  4. Suvankar

    For expansion of industry when we calculate financial cost, we observe that cost of debt fund is lesser. so what should be the optimum level of this ratio?

  5. FIRDOUS

    first of all thanks to the this wonderful effort of making such a website for students

    how can we justify that a company having high geared capital structure is good or bad than a low geared company.I am very much understanding the concept of capital gearing ratio but still i want to know how the usage of more debt and pref. capital should be termed as high geared.

  6. Mahi

    Good clarification is given and which is understandable Thank you

  7. Chand basha mcb

    Thanks…
    well explained

  8. pardeep garg

    good clarificationn and easy.. thknuu

  9. srihari

    Another form of gearing ratio is the times interest earned ratio, which is calculated as shown below, and is intended to provide some indication of whether a company can generate enough profits to pay for its ongoing interest payments.

    Earnings before interest and taxes
    __________________________________
    Interest payable

  10. Rani Bhatia

    Will it be considered wrong if the child writes debt as the numerator and equity as the denominator?

  11. Amir

    Thanks “accountingformanagement” it was very helpful.

  12. Kartik sharma

    As per the modules provided by ICAI capital gearing ratio is fixed interest funds/ equity share holders fund

  13. Sobia Azmat

    In a high financial geared co. The profit will be low?

    1. Fred Ambani

      That might not stand. A company may be highly geared but profitable.

  14. Jamie Shamatombwe

    Good clarification, easy to understand. Thanks.

  15. Ontefetse Mafoko

    thanks for the clarification. Does gearing ratio have another name??

  16. Mohammed Tego

    Thanks for shading more light on the subject of capital gearing ratio.
    Is there another method for computing it?

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