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The capital gearing ratio is an important leverage ratio that helps determine the extent to which a company is funded through debt compared to equity. It is widely used by analysts, creditors, and investors to assess financial risk and long-term sustainability.
Capital gearing ratio measures the proportion of fixed-interest bearing funds (such as debt and preference shares) compared to equity shareholders’ funds. It highlights how a company finances its operations—through borrowed capital or shareholders’ capital.
A company with high gearing relies heavily on debt, which increases financial risk but may result in higher returns if earnings increase, though this also raises financial risk. A company with low gearing, on the other hand, depends more on equity, reducing risk but potentially lowering returns.
The formula is:
Capital Gearing Ratio = Fixed Interest Bearing Funds ÷ Equity Shareholders’ Funds
Where:
Fixed Interest Bearing Funds = Debentures + Loans + Preference Shares
Equity Shareholders’ Funds = Equity Share Capital + Reserves + Surplus
A higher ratio means the business is more reliant on debt, while a lower ratio indicates a stronger equity base.
Suppose Company A has the following capital structure:
Debentures = ₹50,00,000
Preference Shares = ₹20,00,000
Loans = ₹30,00,000
Equity Share Capital + Reserves = ₹1,00,00,000
Fixed Interest Bearing Funds = ₹1,00,00,000
Equity Shareholders’ Funds = ₹1,00,00,000
Capital Gearing Ratio = ₹1,00,00,000 ÷ ₹1,00,00,000 = 1:1
This means the company has an equal proportion of debt and equity financing.
This ratio matters because it helps:
Measure Financial Risk: High gearing indicates more financial risk.
Investor Assessment: Shows how returns may fluctuate with market conditions.
Credit Decisions: Lenders evaluate gearing to decide on loans.
Profit Distribution: High gearing means more profits are used to service debt.
Capital gearing can be classified into two main types:
| Type | Meaning | Implication |
|---|---|---|
High Gearing |
Large proportion of debt compared to equity |
Higher risk, higher potential returns |
Low Gearing |
Larger reliance on equity capital |
Lower risk, more financial stability |
Despite its usefulness, this ratio has limitations:
Does not account for profitability or revenue generation.
May differ across industries, making comparisons tricky.
Ignores short-term liquidity aspects.
Can be distorted by one-time changes in debt or reserves.
The capital gearing ratio is a crucial measure of a company’s capital structure, helping to evaluate the balance between debt and equity financing. While high gearing may increase potential returns during good times, it increases risk during downturns. Investors, creditors, and managers should use this ratio along with other financial metrics for a holistic assessment.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
The capital gearing ratio is also commonly known as the financial leverage ratio or simply gearing ratio. These terms highlight the extent to which a company relies on borrowed funds compared to shareholders’ equity to finance its operations and growth.
High capital gearing means that a company has a significant proportion of debt in its capital structure compared to equity. This situation increases financial risk because the business must meet fixed interest and repayment obligations. However, it can also magnify returns for shareholders during periods of strong earnings.
Low capital gearing means that a company relies more on equity financing than debt. This reduces financial risk since there are fewer fixed interest commitments, making the business more stable during downturns. On the other hand, it may limit potential returns for shareholders because equity financing dilutes ownership and is often costlier than debt.
While both ratios measure leverage, they differ in focus. The capital gearing ratio compares fixed-interest bearing funds (such as loans, debentures, and preference shares) with equity, showing how much of the capital carries mandatory charges. The debt-equity ratio, on the other hand, compares the total debt of a company to its equity capital, giving a broader picture of financial leverage.
The capital gearing ratio is important for investors because it reflects the company’s risk-return profile. A high ratio signals higher risk due to heavy reliance on debt but may also indicate potential for higher returns. A low ratio shows financial stability but possibly slower growth. By evaluating this ratio, investors can make informed decisions about the company’s ability to generate sustainable profits and handle economic fluctuations.
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