Capital Gearing Ratio


Capital Gearing Ratio:

Definition and Explanation:

Closely related to solvency ratio is the capital gearing ratio. Capital gearing ratio is mainly used to analyze the capital structure of a company.

The term capital structure refers to the relationship between the various long-term form of financing such as debentures, preference and equity share capital including reserves and surpluses. Leverage of capital structure ratios are calculated to test the long-term financial position of a firm.

The term “capital gearing” or “leverage” normally refers to the proportion of relationship between equity share capital including reserves and surpluses to preference share capital and other fixed interest bearing funds or loans. In other words it is the proportion between the fixed interest or dividend bearing funds and non fixed interest or dividend bearing funds. Equity share capital includes equity share capital and all reserves and surpluses items that belong to shareholders. Fixed interest bearing funds includes debentures, preference share capital and other long-term loans.

Formula of capital gearing ratio:

[Capital Gearing Ratio = Equity Share Capital / Fixed Interest Bearing Funds]

Example:

Calculate capital gearing ratio from the following data:


Equity Share Capital
Reserves & Surplus
Long Term Loans
6% Debentures
1991 1992
500,000
300,000
250,000
250,000
400,000
200,000
300,000
400,000
Calculation:

Capital Gearing Ratio 1992 = (500,000 + 300,000) / (250,000 + 250,000)

= 8 : 5 (Low Gear)

1993 = (400,000 + 200,000) / (300,000 + 400,000)

6 : 7 (High Gear)

It may be noted that gearing is an inverse ratio to the equity share capital.

Highly Geared————Low Equity Share Capital

Low Geared—————High Equity Share Capital

 

Significance of the ratio:

Capital gearing ratio is important to the company and the prospective investors. It must be carefully planned as it affects the company’s capacity to maintain a uniform dividend policy during difficult trading periods. It reveals the suitability of company’s capitalization.

You may also be interested in other articles from “financial statement analysis” chapter:

  1. Horizontal and Vertical Analysis
  2. Ratios Analysis
  3. Horizontal Analysis or Trend Analysis
  4. Trend Percentage
  5. Vertical Analysis
  6. Accounting Ratios Definition, Advantages, Classification and Limitations:
  7. Gross profit ratio
  8. Net profit ratio
  9. Operating ratio
  10. Expense ratio
  11. Return on shareholders investment or net worth
  12. Return on equity capital
  13. Return on capital employed (ROCE) Ratio
  14. Dividend yield ratio
  15. Dividend payout ratio
  16. Earnings Per Share (EPS) Ratio
  17. Price earning ratio
  18. Current ratio
  19. Liquid/Acid test/Quick ratio
  20. Inventory/Stock turnover ratio
  21. Debtors/Receivables turnover ratio
  22. Average collection period
  23. Creditors/Payable turnover ratio
  24. Working capital turnover ratio
  25. Fixed assets turnover ratio
  26. Over and under trading
  27. Debt-to-equity ratio
  28. Proprietary or Equity ratio
  29. Ratio of fixed assets to shareholders funds
  30. Ratio of current assets to shareholders funds
  31. Interest coverage ratio
  32. Capital gearing ratio
  33. Over and under capitalization
  34. Financial-Accounting- Ratios Formulas
  35. Limitations of Financial Statement Analysis

Other Related Accounting Articles:

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