Understanding financial ratios is essential for businesses, investors, and analysts aiming to evaluate a company’s financial structure. One important ratio used to assess financial risk and capital structure is the capital gearing ratio. This ratio provides insights into how a company finances its operations whether through equity or borrowed funds and helps determine the level of financial leverage. By analyzing the capital gearing ratio formula, stakeholders can gauge the extent to which a company relies on fixed interest-bearing capital, which is critical in decision-making and risk assessment.
Definition of Capital Gearing Ratio
What Is Capital Gearing?
Capital gearing refers to the relationship between equity and fixed-interest-bearing capital such as loans and preference shares. A company is said to be highly geared if it relies heavily on debt or other fixed cost capital, while it is low geared if equity constitutes a larger portion of the capital structure.
Purpose of the Ratio
The capital gearing ratio is used to measure the degree of financial leverage a company uses. It indicates the proportion of fixed-cost capital to equity capital, revealing how risky a company’s capital structure is from the perspective of both investors and lenders.
Capital Gearing Ratio Formula
Standard Formula
The capital gearing ratio is generally calculated using the following formula:
Capital Gearing Ratio = Fixed Interest Capital / Equity Shareholders’ Funds
Where:
- Fixed Interest Capitalincludes long-term loans, debentures, and preference shares.
- Equity Shareholders’ Fundsinclude equity share capital, retained earnings, and reserves.
Sometimes, companies may modify the formula based on specific analysis needs, such as including total capital employed or using market values instead of book values.
Alternate Version
Another version of the capital gearing ratio is:
Capital Gearing Ratio = Fixed Interest Capital / (Equity Share Capital + Reserves)
While both formulas aim to measure the same concept, the choice of which to use depends on the available data and the purpose of analysis.
Components of the Formula Explained
Fixed Interest Capital
This includes any source of funds that obligates the company to pay fixed returns. These instruments increase financial risk during periods of low earnings, as the company must meet these obligations regardless of profitability.
- Debentures: Bonds issued by the company that carry a fixed interest rate.
- Long-Term Loans: Bank loans or borrowings payable over several years.
- Preference Shares: Shares with a fixed dividend payout, usually not subject to company profits.
Equity Shareholders’ Funds
This refers to the owners’ stake in the business. These funds are more flexible, as dividends to equity shareholders are not obligatory and depend on the company’s profitability.
- Equity Capital: Funds raised through the issuance of common shares.
- Reserves and Surpluses: Accumulated profits retained in the business for future growth.
High vs. Low Gearing
High Gearing
A company with a high capital gearing ratio is considered highly geared. This means it relies heavily on debt or other fixed-cost capital. While this can magnify returns during profitable periods, it also increases financial risk during downturns.
Advantages:
- Greater potential return on equity due to leverage.
- Interest payments are tax-deductible in many jurisdictions.
Disadvantages:
- Increased financial risk in low-profit scenarios.
- Higher fixed obligations reduce financial flexibility.
Low Gearing
Low gearing indicates a company is primarily financed by equity rather than debt. This typically reflects a more conservative financial strategy with lower risk.
Advantages:
- Lower financial obligations reduce stress on cash flow.
- Greater financial stability during economic downturns.
Disadvantages:
- Limited financial leverage reduces return on equity.
- May indicate underutilization of cheaper financing options like debt.
Interpreting the Capital Gearing Ratio
What Is a Good Capital Gearing Ratio?
There is no universally ideal gearing ratio, as it varies by industry and business model. However:
- A ratio above 50% is usually considered high gearing.
- A ratio below 25% is generally low gearing.
- Ratios between 25% and 50% suggest moderate gearing.
For capital-intensive industries like infrastructure or utilities, higher gearing is more common and acceptable. In contrast, service-based or technology firms may prefer lower gearing due to their less predictable cash flows.
Impact on Financial Decisions
The capital gearing ratio influences strategic decisions, including dividend policy, investment plans, and fundraising strategies. Highly geared companies may limit dividends to conserve cash or avoid additional debt to protect financial stability.
Examples and Practical Applications
Example Calculation
Consider a company with the following data:
- Debentures: $1,000,000
- Preference Shares: $500,000
- Equity Share Capital: $1,500,000
- Reserves: $1,000,000
Fixed Interest Capital = $1,000,000 + $500,000 = $1,500,000
Equity Shareholders’ Funds = $1,500,000 + $1,000,000 = $2,500,000
Capital Gearing Ratio = $1,500,000 / $2,500,000 = 0.6 or 60%
This means the company is highly geared, indicating a higher reliance on borrowed funds.
Using the Ratio for Analysis
Analysts and investors use the capital gearing ratio alongside other financial ratios such as debt-to-equity, interest coverage, and return on capital employed (ROCE) to form a comprehensive view of a company’s financial health. A sudden increase in the gearing ratio over consecutive periods could signal growing financial stress or aggressive expansion financed through debt.
Limitations of the Capital Gearing Ratio
While informative, the capital gearing ratio does have some limitations:
- It does not account for short-term debt or working capital requirements.
- Market value vs. book value differences can skew results.
- Different accounting treatments may affect comparability across companies.
- Does not measure the company’s ability to service its debt (for that, interest coverage ratio is used).
The capital gearing ratio formula is a fundamental tool in assessing a company’s financial leverage and risk. By comparing fixed interest capital to equity shareholders’ funds, this ratio reveals how a company structures its capital and how much of its financing comes from obligations that must be repaid with interest. A balanced capital structure is essential to ensure financial stability while enabling growth and shareholder value. Whether you are an investor, analyst, or business owner, understanding and correctly applying the capital gearing ratio can provide valuable insights into corporate finance and long-term sustainability.