Capital Gearing Ratio

Capital Gearing Ratio

The capital gearing ratio is a helpful tool for analysing the capital structure of a corporation. To calculate the capital gearing ratio, divide the common shareholders’ equity by funds that bear either fixed interest or dividends.

When doing an analysis of capital structure, one must determine the link between the funds contributed by common shareholders and the funds contributed by those who are entitled to a certain rate of interest or dividend payment on a regular basis.

When the majority of a firm’s capital is made up of equity held by common shareholders, we refer to such corporation as having a low gearing ratio. On the other hand, one may say that the business has a high gear ratio if the majority of its available capital is comprised of funds that either provide a fixed interest rate or dividends.

formula:

Capital gearing ratio = (Common Stockholder^’ s equity)/(Fixed cost cost bearing funds)

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.

Gearing (%) = (longterm Liabilities)/(Capital employed)

Notes:

Long-term liabilities include loans due more than one year + preference shares + mortgages

How can the gearing ratio be evaluated?

• A business with a gearing ratio of more than 50% is traditionally said to be “highly geared”.
• A business with gearing of less than 25% is traditionally described as having “low gearing”
• Something between 25% – 50% would be considered normal for a well-established business which is happy to finance its activities using debt.

It is essential to keep in mind that taking on long-term debt in order to finance a company is not always a negative thing in and of itself. The cost of long-term debt is often rather low, and it minimises the amount of money that shareholders need to put into an organisation.

How much of a gearing reduction is reasonable? Everything hinges on whether or not the company can increase its revenues and maintain a healthy cash flow in order to pay off its obligations. A mature firm that generates stable and consistent cash flows is able to manage a considerably greater degree of gearing than a business where the cash flows are inconsistent and uncertain. This is because the mature business is more financially stable.