Capital gearing ratio

Capital gearing ratio is the ratio of capital with fixed return (i.e. preference share capital plus long term liabilities) to capital with variable return (i.e. ordinary share capital).

The total capital employed of a company comprises of three main segments: equity, preference share capital and long term loans. Equity holders (i.e. ordinary shareholders) are paid a dividend that varies each year with the volume of profits made. Ordinary shareholders are therefore said to have a variable return. On the other hand, both the preference shareholders and long term lenders are paid a fixed rate of return regardless of the level of the company’s profits.The capital provided by these two is therefore said to have a fixed return.

Formula:

The formula of capital gearing ratio is given below:


Capital gearing ratio = Common stockholders’ equity/Fixed cost bearing funds

Example 1:

The following information has been taken from the balance sheet of L & M company.

  • 8%Bonds payable: $800,000
  • 12%Preferred stock: $700,000
  • Common stockholders’ equity: $2,000,000

Required: Compute capital gearing ratio of L & M company.

Solution:

Capital gearing ratio = Common stockholders’ equity/Fixed cost bearing funds


= $2,000,000/$1,500,000*

4 : 3 (Low geared)

*$800,000 + $700,000

The L & M company has a low geared capital structured because common stockholders’ equity is more than the fixed cost bearing funds (total of preferred stock and bonds). For every $4 contributed by common stockholders, there are only $3 contributed by fixed cost bearing funds.

Also Check:  Gross profit ratio

Example 2

The R & G company’s balance sheet as on December 31, 2017 shows total long term debts of $500,000, total preferred share capital of $300,000 and total common share capital of $400,000. Calculate capital gearing ratio of R & G company. Also interpret the capital structure of the company.

Capital gearing ratio = $400,000 : $800,000

1 : 2

The capital gearing ratio is 2 : 1 which means the company is highly geared. For every $1 invested by the common stockholders, there is an investment of $ of preferred stockholders and loan providers.

A company with highly geared capital structure will have to pay high fixed interest costs on long term loans and more dividend on preferred stock and will have to face difficulty in attracting new investors.

What is gearing level?

This is another way of expressing the capital gearing ratio. Gearing level is arrived at by expressing the capital with fixed return (CWFR) as a percentage of capital employed. A company whose CWFR is in excess of 60% of the total capital employed is said to be high geared. A company whose CWFR is between 30% to 50% of its total capital employed is said to be medium geared. A company whose CWFR is below 25% of its total capital employed is said to be low geared. A company that has no CWFR is said to be ungeared, or totally equity funded.

Also Check:  Equity as percentage of Capital Employed

Even a slight decrease in the ROCE of a high geared company can cause a large reduction in its ROE. On the other hand, even a slight improvement in such a company’s ROCE can lead to a large increase in its ROE.

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