Capital Gearing Ratio

Reviewed by Subject Matter Experts

Updated on February 27, 2023

The capital gearing ratio is the ratio of all capital with a fixed return (i.e., preference share capital plus long-term liabilities) to all capital with a variable return (i.e., ordinary share capital).

A company's total capital employed consists of three main segments:

• Preference share capital
• 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.

By contrast, both preference shareholders and long-term lenders are paid a fixed rate of return regardless of the level of the company's profits.

Hence, the capital provided by these two is said to offer a fixed return.

Formula

To calculate the capital gearing ratio, use the following formula:

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 Limited.

• 8% bonds payable: \$800,000
• 12% preferred stock: \$700,000
• Common stockholders' equity: \$2,000,000

Required: Calculate the company's capital gearing ratio.

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

L&M Limited has a low-geared capital structure. This is shown by the fact that the common stockholders' equity exceeds 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.

Example 2

R&G Plc's balance sheet on 31 December 2017 shows total long-term debts of \$500,000, total preferred share capital of \$300,000, and total common share capital of \$400,000.

Required: Calculate the capital gearing ratio of the company and interpret its capital structure.

Solution

The capital gearing ratio is \$400,000 : \$800,000 = 1 : 2.

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

A company with a highly geared capital structure will have to pay high fixed interest costs on long-term loans and more dividends on preferred stock. It will also find it challenging to attract new investors.

What Is the Gearing Level?

The gearing level is another way of expressing the capital gearing ratio.

The 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 highly geared.

A company whose CWFR is between 30% to 50% of its total capital employed is said to be medium geared. Also, a company whose CWFR is below 25% of its total capital employed is said to be low geared.

A company with no CWFR is said to be ungeared (or totally equity funded).

Even a slight decrease in the Return On Capital Employed (ROCE) ratio of a highly geared company can cause a large reduction in its Return On Equity (ROE).

On the other hand, even a slight improvement in such a company’s ROCE can lead to a large increase in its ROE.