Capital gearing ratio is a useful tool to investigate the capital structure of any company and also computed by dividing more common stockholders equity by fixed interest as well as dividend bearing resources.
Analyzing capital construction means measuring the partnership between the funds offered by common stockholders as well as the funds provided by people who receive a periodic interest or dividend for a fixed rate.
A company is reportedly low geared in the event the larger portion of the capital comprises common stockholders’ collateral. On the other hand, the company is reportedly highly geared in the event the larger portion of the capital comprises fixed interest/dividend showing funds.
Within the above formula, the numerator consists of general stockholders equity that is equal to total stockholders equity fewer preferred stock plus the denominator consists associated with fixed interest or maybe dividend bearing funds that usually include long expression loans, bonds, debentures in addition to preferred stock and so forth.
All the information necessary to compute capital gearing ratio can be acquired from the balance sheet.
The following information have been taken from the balance sheet of ABC limited:
We can compute the capital gearing ratio for the years 2011 and 2012 from the above information as follows:
The company has a low geared capital structure in 2011 and highly geared capital structure in 2012.
Notice that the gearing is inverse to the common stockholders’ equity.
Highly geared >>> Less common stockholders’ equity
Low geared >>> More common stockholders’ equity
Significance and interpretation:
Borrowing is a cheap source of funds for many companies but a highly geared company is considered a risky investment by the potential investors because such a company has to pay more interest on loans and dividend on preferred stock and, therefore, may have to face problems in maintaining a good level of dividend for common stockholders during the period of low profits.