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 relevant articles:

Profitability ratios:

Liquidity ratios:

Activity ratios:

Leverage ratios or long term solvency ratios:

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