Understanding Capital Gearing Ratio

This guide explores what capital gearing ratio means, the gearing ratio formula, how to calculate it, its significance, and how it helps assess the strength of a company’s financial structure.

What is the Capital Gearing Ratio?

The term refers to the relationship between a company’s fixed-interest bearing capital and its equity capital. In other words, it measures the proportion of funds obtained through borrowings and preference shares against those contributed by ordinary shareholders. It is often referred to simply as the gearing ratio, and it helps reveal the level of financial leverage a business employs.

The gearing ratio’s meaning can be summarised as the extent to which a company is financed by debt compared to shareholders’ equity. A company with high gearing relies more on borrowed funds, while a low gearing ratio suggests the company’s operations are primarily financed through shareholders’ capital. For Indian firms, which operate under diverse economic and regulatory environments, this ratio provides valuable insights into risk tolerance and funding preferences.

Components of capital gearing ratio

Before delving into the formula of capital gearing ratio, it is important to understand its two main components. These include:

1. Common shareholders’ equity:
   This represents the total capital provided by the owners of the company. It includes equity share capital, share premium, general reserves, and participatory preference shares. Essentially, this component signifies the funds that do not incur any fixed charges and remain in the business indefinitely.
2. Fixed interest-bearing funds:
   These are liabilities that attract fixed interest or dividend payments. They include long-term loans, debentures, bonds, and preference share capital. These funds carry an obligation of fixed payment, regardless of the company’s profitability in a given period.

Together, these two components provide a clear picture of how a company’s financing is structured and the extent of its financial commitments.

The Capital Gearing Ratio formula

The capital gearing ratio formula is typically expressed as follows:

Capital Gearing Ratio = Common Shareholders' EquityFixed interest bearing funds

This gearing ratio formula compares debt or fixed-cost capital to equity capital. By calculating this ratio, analysts can determine the degree of financial leverage a company uses.

Some variations present the inverse relationship, such as:

Capital Gearing Ratio = Fixed interest bearing fundsCommon Shareholders' Equity

However, the interpretation remains consistent: it measures the balance between equity and borrowed funds.

How to calculate gearing ratio

To understand how to calculate gearing ratio, the following steps are followed:

1. Obtain equity figures:
   Extract the total common shareholders’ equity from the company’s balance sheet. This includes share capital, reserves, and any surplus.
2. Determine fixed interest-bearing funds:
   Identify the total amount of fixed-interest liabilities, including long-term loans, debentures, and preference shares.
3. Apply the formula:
   Substitute the values into the capital gearing ratio formula and compute the ratio.

For example:

Capital Gearing Ratio=500/300​=0.6

Alternatively, if the formula is expressed as equity divided by fixed-interest funds:

Capital Gearing Ratio=300/500​=1.67

A ratio of 1.67 means the company’s equity is 1.67 times its fixed-interest obligations. This signifies a relatively stable capital structure with a lower degree of financial risk.

High gearing versus low gearing

Interpreting the ratio involves understanding the implications of high and low gearing.

• High gearing:
  A company is said to be highly geared when it has more fixed-interest-bearing funds than equity. This indicates a higher reliance on debt and, consequently, greater financial leverage. While this may amplify returns during profitable periods, it also increases the burden of fixed obligations during downturns.
• Low gearing:
  A low gearing company, on the other hand, has a larger proportion of equity capital relative to debt. This implies lower financial risk and greater stability but may also indicate a conservative approach that limits potential growth through leverage.

In India, where industries such as infrastructure, power, and telecommunications tend to be capital-intensive, a higher gearing ratio is often common. Conversely, sectors such as IT and services typically operate with lower gearing.

Importance of capital gearing ratio

The capital gearing ratio is a vital indicator for investors, lenders, and financial managers. Its importance can be viewed from multiple perspectives:

1. Assessing financial risk:
   The ratio reveals the extent of a company’s fixed financial commitments, which helps gauge its ability to service debt during economic fluctuations.
2. Investment evaluation:
   Investors use the ratio to understand the risk-return balance. Companies with high gearing may offer higher returns but carry greater financial risk.
3. Credit assessment:
   Lenders examine this ratio to determine a company’s creditworthiness and ability to meet long-term obligations.
4. Capital structure planning:
   It assists management in determining an optimal mix of debt and equity to minimise the cost of capital while maintaining financial flexibility.

Factors affecting capital gearing ratio

Several internal and external factors influence the gearing ratio. These include:

• Industry norms:
  Capital-intensive sectors naturally exhibit higher gearing ratios compared to asset-light industries.
• Economic environment:
  Interest rate movements and overall economic stability affect borrowing costs and leverage decisions.
• Profitability and cash flow:
  Companies with stable and predictable earnings can sustain higher levels of gearing.
• Regulatory framework:
  Financial regulations and tax policies in India often affect the choice between equity and debt financing.

Each of these factors plays a crucial role in determining a company’s financial strategy and capital composition.

Advantages and disadvantages of capital gearing ratio

Advantages

• Provides a clear measure of financial leverage.
• Helps investors and creditors assess the level of financial risk.
• Aids in capital structure optimisation and planning.
• Facilitates benchmarking against industry standards.

Disadvantages

• Excludes short-term liabilities from consideration.
• A high gearing ratio can increase vulnerability during downturns.
• Cross-industry comparisons may be misleading without proper context.
• The ratio does not directly measure profitability or liquidity.

Thus, while useful, the capital gearing ratio should be analysed in conjunction with other financial metrics for a holistic view.

Capital gearing ratio versus debt-equity ratio

Although the capital gearing ratio and the debt-equity ratio appear similar, they differ slightly in purpose and computation.

Both ratios together can provide deeper insights into a company’s financial structure and borrowing strategy.

Real-world applications

In practice, companies across industries exhibit different gearing levels. For instance:

• Large industrial and infrastructure firms such as Reliance Industries and Tata Steel often display higher gearing ratios, reflecting their reliance on long-term borrowing to finance large projects.
• Conversely, technology and service-based firms like Infosys or Wipro generally have low gearing, indicating stronger equity financing and minimal debt obligations.

These examples highlight how sectoral characteristics, growth strategies, and market conditions influence gearing structures.

How companies manage capital gearing ratio

Effective management of the gearing ratio is essential for maintaining financial stability. Companies can control or adjust their gearing by:

1. Issuing additional equity:
   This reduces reliance on debt and strengthens the equity base.
2. Refinancing existing loans:
   Negotiating better terms or restructuring debt can help lower the interest burden.
3. Retaining earnings:
   Increasing retained profits enhances shareholders’ equity without new financing.
4. Balancing dividend policies:
   Adjusting dividend payouts can help retain more funds for reinvestment.

Each strategy depends on the company’s growth phase, cost of capital, and market conditions.

Common misconceptions about capital gearing ratio

Several misunderstandings exist regarding the interpretation of the capital gearing ratio:

• Misconception 1: High gearing always signals financial distress.
  Reality: In stable industries with predictable cash flows, high gearing can be sustainable and even beneficial due to tax advantages on interest.
• Misconception 2: Low gearing is always favourable.
  Reality: Excessively low gearing might indicate underutilisation of financial leverage, potentially leading to lower returns on equity.
• Misconception 3: Only loans are considered in gearing.
  Reality: Preference shares and other fixed-dividend instruments are also part of fixed-interest-bearing capital.

Understanding these nuances ensures that analysts interpret the ratio in context rather than in isolation.

Conclusion

The capital gearing ratio remains an important part of financial analysis, offering a clear view of a company’s funding balance between equity and debt. It assists in identifying financial risk, efficiency in capital structure, and overall stability. For investors and financial analysts in the Indian market, where industries vary greatly in capital intensity, understanding this ratio is crucial for making informed decisions.

While no single measure can provide a complete picture, the gearing ratio, when applied correctly and interpreted alongside other financial indicators, becomes a valuable tool for assessing financial resilience. Whether evaluating investment opportunities or managing internal finances, knowledge of what is gearing ratio, how to calculate gearing ratio, and its implications forms the foundation of sound financial judgment.