Capital Gearing Ratio

Capital gearing ratio is the ratio between total equity and total debt; this is a specifically important metric when an analyst is trying to invest in a company and wants to compare whether the company is holding the right capital structure.

The Capital Gearing Ratio tells us about companies’ capital structure. Broadly, Capital Gearing is nothing but Equity to Total Debt Ratio. This critical information about capital structure makes this ratio one of the most significant before investing.

The capital gearing ratio helps investors understand how geared the firm's capital is. The firm's capital can either be low geared or high geared. For example, when a firm's capital is composed of more common stocks than other fixed interest or dividend-bearing funds, it's said to have been low geared. On the other hand, it's highly geared when the firm's capital consists of less common stocks and more interest or dividend-bearing funds.

Why does it matter to know whether the firm's capital is high geared or low geared? Here's why. Companies that are low geared tend to pay less interest or dividends, ensuring the interest of common stockholders. On the other hand, highly geared companies need to give more interest, increasing investors' risk. For this reason, banks and financial institutions don't want to lend money to companies that are already highly geared.

Also, have a look at Capitalization Ratio

Now let's look at the formula to calculate the ratio all by ourselves to understand the nitty-gritty of a firm's capital structure.

Here's how to calculate the capital gearing ratio –

Capital Gearing Ratio = Common Stockholders' Equity / Fixed Interest bearing funds.

Let's understand what we will include in the Common Stockholders' Equity and Fixed (income) Interest-bearing funds.

• Common Stockholders' Equity: We will take the shareholders' equity and deduct the Preferred Stock (if any).
• Fixed Interest bearing funds: Here, the list is long. We need to include many components on which the companies pay interest. For example, we will include long-term loans/debts, debentures, bonds, and preferred stock.

So from the above, it's clear that we will take the simple ratio between common stock and all other components of capital structure. And from the ratio, we would be able to understand whether the company's capital is high geared or low geared.

First of all, capital gearing ratio is also called financial leverage. Financial leverage is a good thing for a firm that needs to expand its reach. But at the same time, it's equally useful for a firm to generate enough income to pay off the interest for the loans they have borrowed and pay off the debt. That's why high geared companies are at great risk when any economic downturn happens. During the economic crash, these companies filed for bankruptcy. Thus, depending too much on debt to pay for the continuing operation of the firm is always not a good idea. So what do the firms need? The one-word answer is "balance."

Secondly, there is one concept that companies pay heed to when designing their capital gearing, and that is "equity trading." As capital gearing should be planned well in advance, companies must value this concept of "trading on equity". It means as long as the business's net income is more than the cost of interest payment, the common stock shareholders would keep gaining their share, which can be called "wealth maximization of shareholders." Many business thinkers argue that "maximizing the wealth of shareholders" is one of the most important purposes. So that's why it's important to understand whether the company is highly geared or low geared and how the company is doing in terms of covering the interest payment and earning a decent profit.

Let us consider the following examples to understand the capital gearing ratio definition better.

Example #1

We have the following information about Company A –

We need to find out the capital gearing ratio.

This example is basic, and we will just put the value into the proper place to find out the ratio.

Capital Gearing Ratio = Common Stockholders' Equity / Fixed Interest bearing funds

From the above ratio, we can conclude that debt is more prevalent in the capital structure than shareholders' equity. Thus, it is highly geared.

Example #2

MNP Company has provided with the information below for the last 2 years –

We need to calculate the capital gearing ratio and see whether the firm is high geared or low geared for the last two years.

From the above example, we can see that preferred stock and bonds are dividend & interest-bearing funds. And we also have been given common equity.

So by summing up the interest/dividend bearing funds, we get –

Now we can calculate the capital gearing ratio for the last 2 years –

According to this ratio, we can easily say that in 2015, the firm was high geared. But later, as the common equity increased in 2016, the firm's capital structure became low geared. The idea is to see the proportion of common stock equity and the interest/dividend-bearing funds in a capital structure. If the firm's capital structure consists of more interest/dividend-bearing funds, then the firm's capital is highly geared and vice versa.

Example #3

Let's look at the information below furnished by F Corporation –

 Calculate the capital gearing ratio for F Corporation.

Here, there is an interesting addition. We can see that a bank overdraft is being given. So, should we include bank overdraft in the common stock-holding, or should we include it in the interest-bearing funds?

If we look closely, we would see that a bank overdraft is one form of a loan that demands interest by offering the extra borrower cash when he doesn't have any in his account. So for a bank overdraft, the borrower needs to pay interest. That means it should be included in the interest-bearing funds.

So, let's calculate the interest/dividend bearing funds in the case of this example –

Now, this ratio would be –

In this case, the firm's capital is highly geared.

Now the question remains, what would a firm do if it finds out that its capital is highly geared, and it needs to take action to make the capital low geared gradually.

The below snapshot is the Consolidated balance sheet of Nestle as of 31^st December 2014 & 2015

source: Nestle

Calculation of Nestle's total debt in 2015 and 2014 is as follows -

• The Current Portion of Financial Debt was CHF 9,629 and CHF 8,810 in 2015  and 2014, respectively.
• Long Term Portion of Debt = CHF 11,601 (2015) & CHF 12,396 (2014)
• Total Debt (2015) = CHF 9,629 + CHF 11,601 = CHF 21,230
• Total Debt (2014 ) = CHF 8,810 + CHF 12,396 = CHF 21,206

Calculating Capital Gearing Ratio

The Capital Gearing ratio had decreased from 3.38x in 2014 to 3.01x in 2015. This ratio decreased primarily due to the decrease in equity contributed by the buyback of treasury shares and a decrease in translation reserves.

Below is the Equity to Debt graph of Exxon, Royal Dutch, BP, Noble Energy, and Chevron.

Data source: ycharts

The table below provides us with Capital Gearing ratios from 2007 - 2015 of these Oil & Gas companies.

Data Source: ycharts

A common trend across all companies in the decrease of capital gearing ratio, especially after 2013. In 2013-2014, a slowdown in commodity (oil) prices started, and this is where most oil and gas companies got hit. As a result, these companies could not generate strong cash flows from operations and relied on debt as a funding source, increasing their total debt. This increase in debt resulted in a decrease in ratio.

Why do you think Pepsi's Capital Gearing Ratio decreased?

Data source: ycharts

The capital Gearing Ratio can decrease because of three reasons -

1. Increase in Debt
2. Decrease in Equity
3. Both (1) and (2), contribute meaningfully.

Let us look at Pepsi's Debt and Equity over the years in the graph below.

source: ycharts

We note that debt has steadily increased over the past five years. For example, in 2015, Pepsi's debt was $32.28 billion compared to $28.90 billion.

However, what is important to note is a sudden change in the Shareholder's equity. Pepsi's shareholders' equity decreased from $24.28 billion in 2013 to $11.92 billion in 2015.

Let us investigate what has caused this sudden decrease in Shareholder equity.

Below is a snapshot of Pepsi's Balance Sheet Shareholder's Equity section of 2015 and 2014.

source: Pepsi SEC Filings

We note that two items have contributed to a decrease in Shareholder's equity.

• Increase in Accumulated Other comprehensive losses. These losses have not been realized and may include forex gains/losses, unrealized gains/losses on securities, etc.
• Buyback of Shares that have increased Treasury stock. This buyback of shares resulted in a decrease in Shareholder's Equity.

As we can see from above, the major contributing factor to the decrease in the Capital Gearing Ratio of Pepsi was the sharp decrease in Shareholder Equity.

There are usually four things a firm can do to reduce capital gearing. There are a couple of reasons firms should reduce their capital gearing.

First, the firm needs to attract more investors by making it easy. If the firm's capital is highly geared, it would be too risky for the investors to invest. Thus, until and unless the firm reduces its capital gearing, it would not be easy to attract more investors.

Second, the firm needs to follow the principle of perpetuity. If the firm's capital is geared higher for a long period, then it would be difficult for them to pay off the debt, and as a result, they need to file for bankruptcy.

So what are four things firms can do to reduce capital gearing?

Here are they –

• Increase profits for the period: The best and most prudent way to reduce capital gearing is to earn more profits. If the firm can generate more cash flow (more profits don't always mean more cash inflow, but more cash inflow may usually mean better profits), it would be easier to pay off the debt and reduce the high geared ratio.
• Try to reduce working capital: If the firms have to reduce working capital, they need to reduce the inventory levels, receive the payment from debtors quickly, and lengthen the time of payment to creditors. More cash in less time will help pay off the debt quickly. (also, look at working capital ratio)
• Convert loans into shares: The firms can convert loans into shares by offering shares instead of cash. It will help in two ways. First of all, firms wouldn't need to generate more cash to pay off debt. And secondly, even if the firms have more cash, they would be able to use it elsewhere, and as a result, the debt would convert into shares.
• Sell shares to generate cash: If firms can sell shares, they will have their cash to pay off debts. But this is not a very good idea if a firm wants to stay in business for a very long time.

The capital gearing ratio is more important than considered. It is one of the first things you should see if you want to invest in a company. The way a company decides to finance its projects says a lot about the company's long-term existence. If the company consistently takes high risks because it needs to invest in profitable projects, you should consider them before investing. Without prudence, no planning can be successful. So look at the capital gearing ratio of the company, look at the net cash flow of the company, and look at the net income of the company before making any decision about the investment.

Capital Gearing Ratio is a useful ratio to find out whether a firm's capital is properly utilized or not. To investors, the importance of the capital gearing ratio lies in whether the investment is risky or not. For example, if the firm's capital consists of more interest-bearing funds, it is a riskier investment to the investors. On the other hand, if the firm has more common equity, the investors' interest would be taken care of.

The only possible limitation of the capital gearing ratio is this – this ratio is not the only ratio you should look at whenever you think of investing in a company. Here's the basic logic behind this.

Let's say you are looking at the capital structure of Company A. Company A has 40% common stock and 60% borrowed funds in the year 2016. Now you judge that Company A would be a risky investment because it is highly geared. But to get a big picture, you need to look beyond one or two years of data. You need to look at the last decade of the company's capital structure and then see whether Company A has been maintaining high gear for a longer period. If yes, then it's a riskier investment. But if it's not the scenario and they have borrowed some debt for their immediate need, you can think about investment (subject to the fact that you check other ratios of the company as well).

A guide to what is Capital Gearing Ratio. We explain its formula along with examples showing calculation, interpretation, and significance. You can learn more about accounting and financing from the following articles –

• Degree of Financial Leverage Formula
• Dividend Yield Ratio Calculation
• Dividend Payout Ratio Example
• Interest Coverage Ratio