Definition
The Capital Gearing Ratio is a financial metric that evaluates a company’s financial stability, specifically regarding its capital structure. It’s calculated by dividing the company’s long-term debt by its equity capital. It provides insight into the proportion of the company’s financing that comes from debt relative to equity, thus indicating the financial risk the company may face in terms of debt repayment.
Key Takeaways
- The Capital Gearing Ratio is a financial metric that shows a company’s financial risk by comparing its owner’s equity to borrowed funds. It helps investors understand a company’s financial leverage and overall financial health.
- This ratio is important for investors because a higher Capital Gearing Ratio may indicate a higher risk associated with investment in the company. It signifies the extent to which a company is funded by debt and potential vulnerability to changes in interest rates or credit availability.
- Conversely, a lower ratio suggests a stronger equity position, lower financial risk, and potentially greater financial flexibility. However, it may also indicate that a company is not maximizing the potential benefits of financial leverage.
Importance
The finance term Capital Gearing Ratio is important as it helps to determine the financial risk and stability of a business by assessing the proportion of a company’s long-term debt compared to its equity capital.
A high ratio indicates higher levels of debt, suggesting that the business is high risk and potentially financially unstable, as it relies heavily on borrowed money for financing operations.
This can impact the company’s ability to secure additional funding and the cost of repayment.
Conversely, a low ratio indicates that the company is primarily financed by shareholders’ equity, suggesting healthier financial management, and usually, a less risk for investors or creditors.
By monitoring and understanding this ratio, businesses and investors can make more informed financial and investment decisions.
Explanation
The Capital Gearing Ratio is a key financial metric that companies use to measure their financial stability and long-term solvability. Essentially, this ratio illuminates the company’s capital structure and the extent to which its activities are funded by debt versus equity. Understanding this balance is critical for both internal management and potential investors, as it provides insights into the financial risk associated with the company.
A high gearing ratio may indicate a higher risk of bankruptcy if the company is not able to meet its financial obligations, whereas a low ratio signifies a safer financial position and greater operational flexibility. The primary purpose of the Capital Gearing Ratio is to provide a detailed view of the company’s financial leverage. It’s used by investors, creditors, and the company’s management team to make informed decisions.
For investors, the ratio could impact their investment choices as a higher ratio may indicate higher risk. On the other hand, creditors use this ratio to determine the company’s ability to repay its debts. Ultimately, the capital gearing ratio serves as a key indicator of the financial health and stability of a company, offering valuable insights into its potential future performance.
Examples of Capital Gearing Ratio
“XYZ Corp”:In year 2020, XYZ Corp had a long-term debt of $500,000 and equity capital of $1,000,Thus, the Capital Gearing Ratio for XYZ Corp is: Long-term debt / Equity Capital i.e. 500,000/1,000,000 =
This implies the company is low geared and has lesser financial risk as it has a larger proportion of equity financing relative to debt financing.”ABC Limited”:ABC Limited, a beverage company, provides an example of a high capital gearing ratio. In 2021, ABC had long-term debts of $5 million and equity capital of $2 million. The capital gearing ratio is therefore 5 million / 2 million =
This high ratio shows that ABC Limited is high geared, indicating that they have a higher level of debt compared to equity. This may pose a greater financial risk.”Tech Solutions Inc”:Tech Solutions Inc, a tech startup, in its initial years decided to heavily rely on loans for its growth strategies due to lack of sufficient equity capital. Say, they had long term debts of $4 million and equity capital was $1 million. Therefore, its capital gearing ratio was 4, which is considered highly geared. This suggests that the company is running with high financial risk. However, if the company’s growth strategies succeed, the high financial leverage can result in increased return on equity.
Capital Gearing Ratio FAQ
What is Capital Gearing Ratio?
The Capital Gearing Ratio, also known as the financial leverage ratio, is a financial metric that evaluates a company’s capital structure by determining the proportion of the funds provided by the company’s equity shareholders against those provided by its creditors. It is an important measure to understand the financial risk and stability of a company.
How is Capital Gearing Ratio calculated?
The Capital Gearing Ratio can be calculated using the following formula: Capital Gearing Ratio = (Long Term Debts / Equity Share Capital) × 100. Long Term Debts include long-term borrowings and equity share capital includes share capital, and reserves and surplus.
Why is Capital Gearing Ratio important?
This ratio is important because it helps the stakeholders to understand the company’s financial stability. A high gearing ratio indicates a high level of debts, which could mean higher risk, while a low gearing ratio suggests a higher degree of financial stability. It lets stakeholders make informed decisions about investing or lending to the company.
What is considered a good Capital Gearing Ratio?
A ‘good’ Capital Gearing Ratio can vary across different industries and individual companies. However, as a general rule of thumb, a Capital Gearing Ratio below 0.5 is typically considered low (better), while a ratio above 0.5 could indicate higher risk. Nevertheless, it’s important to compare the ratio with industry averages and the company’s historical trend to make a comprehensive judgement.
Can a company have a negative Capital Gearing Ratio?
Yes, a company can have a negative Capital Gearing Ratio. This happens when the Equity Share Capital of a company exceeds its Long-Term Debts. While this could mean more financial stability, excessive equity could also indicate under-utilization of debt, which may not be beneficial for the company as it may miss out on possible tax benefits from interest costs.
Related Entrepreneurship Terms
- Equity Capital
- Financial Leverage
- Debt-to-Equity Ratio
- Working Capital Ratio
- Equity Financing
Sources for More Information
- Investopedia: A comprehensive financial website with a huge resource of investing and personal finance education.
- Accounting Tools: This site provides resources for students, professors, and professionals on accounting and finance content.
- Corporate Finance Institute (CFI): A leading provider of online finance courses and certifications.
- The Balance: An expansive personal finance website giving advice on managing money, investing, and financial planning.
