How To Calculate Capital Gearing Ratio
Understanding how to calculate the capital gearing ratio is crucial for anyone involved in financial analysis, corporate finance, or investment decisions. This ratio helps assess the financial structure of a business and measures the level of risk associated with its capital structure. A company with high gearing is more dependent on borrowed funds, which may increase its risk during periods of economic uncertainty. Learning how to accurately compute and interpret this ratio provides valuable insight into a company’s long-term financial health.
What Is Capital Gearing Ratio?
The capital gearing ratio is a financial metric that shows the proportion of a company’s capital that comes from debt compared to equity. It’s particularly useful for evaluating how a company finances its operations through shareholders’ equity or borrowed funds. The higher the gearing ratio, the more leveraged a company is, indicating a higher financial risk.
In simple terms, the capital gearing ratio compares fixed-interest-bearing debt to equity. Investors, analysts, and creditors use this ratio to assess whether a firm is over-reliant on debt and how well it can manage financial obligations in the long term.
Why Capital Gearing Ratio Matters
This ratio is important for several reasons:
- It helps identify the level of financial risk the company carries.
- It provides a snapshot of the company’s capital structure.
- It helps in comparing companies within the same industry.
- It influences investor and creditor confidence.
- It can affect interest rates and the cost of capital for the company.
Formula for Capital Gearing Ratio
There are a few variations in the formula used to calculate the capital gearing ratio, depending on what exactly is being compared. The most commonly used formula is:
Capital Gearing Ratio = Fixed Interest Capital / Equity Shareholders’ Funds
Where:
- Fixed Interest Capitalrefers to long-term liabilities such as debentures, preference shares, and long-term loans.
- Equity Shareholders’ Fundsinclude ordinary share capital and reserves (like retained earnings).
This formula gives a straightforward view of how much fixed-cost capital a company is using relative to the owners’ equity.
Alternative Formula
Another version of the formula includes total capital employed:
Capital Gearing Ratio = Fixed Interest Capital / (Fixed Interest Capital + Equity Shareholders’ Funds)
This version presents the fixed-interest component as a proportion of total long-term capital.
Step-by-Step Guide to Calculating Capital Gearing Ratio
To calculate the capital gearing ratio for a company, follow these steps:
Step 1: Identify Fixed Interest Capital
Look at the company’s balance sheet and find all sources of fixed interest-bearing debt. This may include:
- Long-term loans
- Debentures
- Preference shares
Step 2: Determine Equity Shareholders’ Funds
This includes:
- Ordinary share capital
- Retained earnings
- Share premium account (if applicable)
- Other equity reserves
Step 3: Apply the Formula
Once you have both components, plug the values into the formula. For example:
Assume a company has:
- Long-term loans: $500,000
- Preference shares: $100,000
- Ordinary share capital: $600,000
- Retained earnings: $300,000
Total Fixed Interest Capital = $500,000 + $100,000 = $600,000
Total Equity Shareholders’ Funds = $600,000 + $300,000 = $900,000
Capital Gearing Ratio = 600,000 / 900,000 = 0.67
Expressed as a ratio, this would be 0.67:1 or 67%, meaning for every dollar of equity, there is 67 cents of fixed-interest capital.
How to Interpret the Capital Gearing Ratio
High Gearing
A high capital gearing ratio indicates that a significant portion of the company’s capital comes from debt. This suggests higher financial risk because the company must pay interest and principal repayments regardless of its profitability.
Low Gearing
A low gearing ratio indicates a lower dependence on borrowed funds and that the business relies more on shareholder capital. While this means lower risk, it may also suggest the company is not maximizing growth through leverage.
Optimal Gearing Ratio
There is no universally ideal gearing ratio. What’s considered healthy depends on the industry, the economic environment, and the company’s specific financial strategy. Capital-intensive industries like utilities may have higher acceptable gearing, while service industries tend to have lower ratios.
Factors Affecting Capital Gearing
Several factors can influence the gearing ratio of a company:
- Industry Norms: Some industries naturally operate with more debt.
- Company Lifecycle: Startups might rely more on equity, while mature companies might use more debt.
- Interest Rates: Higher interest rates make debt more expensive, influencing capital decisions.
- Tax Benefits: Interest on debt is tax-deductible, making it attractive under certain tax regimes.
- Management Philosophy: Conservative vs aggressive financial strategies will impact gearing.
Advantages and Disadvantages of High Capital Gearing
Advantages
- Can lead to higher returns on equity during profitable periods
- Tax benefits from interest expense deductions
- Enables growth without diluting ownership
Disadvantages
- Higher financial risk during downturns
- Greater burden of interest and repayment obligations
- Can negatively affect credit ratings
Practical Use of Capital Gearing Ratio
Analysts use the capital gearing ratio in conjunction with other financial ratios such as the debt-to-equity ratio, interest coverage ratio, and return on equity. This provides a broader picture of a company’s financial position and risk profile. When reviewing financial statements, particularly in investment decisions or during mergers and acquisitions, the capital gearing ratio is a key metric in evaluating whether a company is financially balanced or over-leveraged.
Learning how to calculate the capital gearing ratio and interpret its meaning is essential for financial analysis. It reveals important information about a company’s use of debt versus equity and helps stakeholders evaluate the associated financial risks. By understanding this ratio, you can make more informed decisions whether you’re a business owner, investor, or financial professional. Be sure to use accurate, up-to-date financial data and always consider industry context when analyzing gearing ratios.