Capital Gearing Ratio: Formula and Explanation

Capital gearing ratio is a financial tool to analyze the company's 'capital structure' by using its common shareholders' equity and level of obligations in the company.

The word 'capital structure' makes the ratio more important to take at an investment decision.

## What is Capital Gearing Ratio?

The Capital Gearing ratio is also known as an "evenly geared firm" that establishes the relationship between the funds raised by the equity shareholders by the company and the funds borrowed by the company.

The capital gearing ratio helps investors to comprehend how geared the capital of a company is.

If the capital of a company consists of more owner funds or common stocks than fixed-interest funds, it's said to be low geared.

Similarly, if the capital of a company consists of more fixed interest funds or dividend-bearing funds than common stocks, then it's said to be highly geared.

## What is Capital Gearing?

Capital gearing is known as financial leverage that assesses the financial risk of a company. Capital gearing composed of the debt of a company has relative to shareholders' funds.

A company with high levels of capital gearing indicates a larger percentage of debt relative to its shareholders' fund. A company with a gearing ratio of 3.0 would have thrice as much debt as equity.

## Capital Gearing Ratio Formula

The capital gearing ratio is called financial leverage and analyses the financial ability of the company.

The capital gearing ratio formula is calculated by dividing common shareholders' equity by fixed interest funds or dividend-bearing funds.

Capital Gearing Ratio = (Common Shareholders' Equity /  Fixed Interest Bearing Funds)

## Common Shareholders' Equity

Common shareholder's equity means when a company needs money then the company issues shares to the shareholders instead of giving ownership of the company.

Common shareholders' equity is taken as equity and subtracted from the Preferred Stock and it includes share capital and reserve & Surplus.

## Fixed Interest Bearing Funds

Fixed interest-bearing capital means when a company takes a loan from the bank, then the company has to be paid interest at fixed rates. It includes Preference shares, debentures, bonds, short term liabilities and long term liabilities.

## Capital Gearing Ratio Example

Suppose, it is an XYZ company. Here is some information about the XYZ company,

The balance sheet of XYZ company as on 31.3.19

Particular Amount
Non-current assets
Fixed assets 425,000
Long term investments 390,000
Total non-current assets 815,000
Current assets
Cash in hand 20,000
Bills receivable 50,000
Inventory 250,000
Prepaid expenses 100,000
Short term loans 200,000
Total current assets 620,000
Total assets 14,35,000
Equity
Share capital 600,000
Reserve 330,000
Total equity 930,000
Non-current liabilities
Debentures 200,000
Long-term loans 150,000
Total non-current liabilities 350,000
Current liabilities
Bills payable 50,000
Overdraft 100,000
Short-term loans 5,000
Total current liabilities 155,000
Total equity and liabilities 14,35,000

Capital Gearing Ratio = (630000 / 655000)

Capital Gearing Ratio = 0.96 times

The company XYZ has a relatively high capital gearing ratio.

The XYZ company has high financial risk. Hence, the investors should avoid such kinds of companies.

## What is a good capital gearing ratio?

A good capital gearing ratio is considered to be the individual company comparative to other companies within a similar industry.

Here are a few terminologies on good or bad capital gearing ratios.

1. Capital gearing ratio higher than 1 indicates a very high financial risk of the company and the company may go bankrupt.

2. Capital gearing ratio between 0.5 to 1 which also indicates a high financial risk of the company.

3. Capital gearing ratio between 0.25 to 0.5 is typically optimal for stable companies.

4. Capital gearing ratio less than 0.25 is typically considered low risk by both investors and lenders.

## Capital Gearing Ratio Interpretation

The capital gearing ratio is a solvency ratio which is a very helpful metric to evaluate the capital structure and financial stability of the company.

A higher capital gearing ratio shows the larger portion of the capital is composed of fixed interest or fixed dividend. Hence, a high gearing ratio is always risky.

During the recession, these companies filed for bankruptcy, because too much debt is harmful to a company.

A lower capital gearing ratio shows a larger percentage of capital is composed of common equity shareholders than fixed income bearing funds and companies can survive better in difficult times. A low gearing ratio is always less risky.

Usually, investors or lenders prefer a low capital ratio and low gearing ratios to minimize the risk of both investors and lenders.

Both lenders and investors investigate a company's gearing ratio because it indicates the level of risk involved with the company.

It is more meaningful when you compare companies in the same sector with the help of gearing ratio and better to find out a trend of the last five years capital gearing ratio.

Capital intensive companies like industrials are likely to have more debt versus companies with lesser fixed assets.

As a rule of thumb, the capital gearing ratio should be less than 0.25. It is important to note debt financing is always harmful, not at all. Debt can help expand the operation of the company.

Debt financing is a cheap source of funds for many companies but whether a company makes a profit or not, the company has to pay interest at a fixed rate.

Investors should be careful when analyzing the company. While analyzing a  company many factors are to be considered and the capital gearing ratio is one of them.

## How a company can decrease the Capital Gearing Ratio?

There are several ways a company can decrease the capital gearing ratio. These are the following:

#### 1. Increase profit margins for the period

The most efficient way to reduce capital gearing is to increase the profit margins.

If a company generates more cash flow then it will be manageable for the company to repay the debt and decrease the high gearing ratio.

#### 2. Convert loans into shares

A company can convert loans into shares by giving shares rather than cash. Hence, a company does not require to generate more cash to pay off the debt and obligations.

#### 3. Reduce working capital

If a company can reduce working capital such as collecting money from the debtors soon, inventory levels etc. Hence, more cash will assist you to pay off the debt shortly.

#### 4. Generated cash from the sell shares

If a company can sell its shares, then the company would easily pay off the debt.