Capital Gearing Ratio:
Definition and Explanation:
Closely related to solvency ratio is the capital gearing ratio.
gearing ratio is mainly used to analyze the capital structure of a company.
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]
Calculate capital gearing ratio from the following data:
Equity Share Capital
Reserves & Surplus
Long Term Loans
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.