by 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 = (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
Capital employed = Share capital + retained earnings + long-term liabilities
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 important to remember that financing a business through long-term debt is not necessarily a bad thing! Long-term debt is normally cheap, and it reduces the amount that shareholders have to invest in the business.
What is a sensible level of gearing? Much depends on the ability of the business to grow profits and generate positive cash flow to service the debt. A mature business which produces strong and reliable cash flows can handle a much higher level of gearing than a business where the cash flows are unpredictable and uncertain.
Another important point to remember is that the long-term capital structure of the business is very much in the control of the shareholders and management. Steps can be taken to change or manage the level of gearing for example:
Reduce Gearing |
Increase Gearing |
| Focus on Profit improvement | Focus on growth |
| Repay long-term loans | Convert short term debt into long term loans |
| Retain profits rather than pay Dividends | Buy-back ordinary shares |
| Issue more Shares | Pay increased dividends out of retained earning |
| Convert loans into equity | Issue preference shares or debentures |
