What is 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 a right capital structure or not.
Capital Gearing Ratio of most Oil & Gas companies took a plunge since 2013. Why? Is this good or bad?
But first, What is the Capital Gearing ratio? it tells us about companies’ capital structure. Broadly, Capital Gearing is nothing but the ratio of Equity to Total Debt. This critical information about capital structure makes this ratio as one of the most significant ratios to look at before investing.
Through this ratio, investors can understand how geared the capital of the firm is. The firm’s capital can either be low geared or high geared. When a firm’s capital is composed of more common stocks rather than other fixed interest or dividend-bearing funds, it’s said to have been low geared. On the other hand, when the firm’s capital consists of less common stocks and more of interest or dividend-bearing funds, it’s said to be highly geared.
Now why it matters to know whether the firm’s capital is high geared or low geared? Here’s why. Companies which are low geared tend to pay less interests or dividends ensuring the interest of common stockholders. On the other hand, high geared companies need to give more interest increasing the risk of investors. For this reason, banks and financial institutions don’t want to lend money to the companies which are already highly geared.
Also, have a look at Capitalization Ratio
Capital Gearing Ratio Formula
Now let’s have a closer look at the formula so that we can calculate the ratio all by ourselves to understand the nitty-gritty of a firm’s capital structure.
Here’s how you can calculate 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 a lot of 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.
Interpretation of Capital Gearing Ratio
First of all, capital gearing ratio is also called as financial leverage. Financial leverage is a good thing for a firm who needs to expand their reach. But at the same time, it’s equally useful for a firm to generate enough income to pay off the interests 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 file 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 “trading on equity”. As capital gearing should be planned well in advance, it’s important that companies value this concept of “trading on equity”. It means as long as the net income of the business is more than the cost of interest payment, the common stock shareholders would keep on gaining their share which in simple terms can be called “wealth maximization of shareholders”. Many business thinkers argue that “maximizing the wealth of shareholders” is one of the most important purposes of running a business. 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.
Capital Gearing Ratio Example
We will take few examples to illustrate capital gearing so that we can cover this concept from all aspects.
Example # 1
We have the following information about Company A –
| Details | In US $ |
| Shareholders’ Equity | 300,000 |
| Short term Debt | 200,000 |
| Long term Debt | 300,000 |
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.
| Details | In US $ |
| Short term Debt (1) | 200,000 |
| Long term Debt (2) | 300,000 |
| Funds bearing interest (1+2) | 500,000 |
Capital Gearing Ratio = Common Stockholders’ Equity / Fixed Interest bearing funds
| Details | In US $ |
| Shareholders’ Equity (3) | 300,000 |
| Funds bearing interest (4) | 500,000 |
| Capital Gearing Ratio | 3:5 (High geared) |
From the above ratio, we can conclude that the 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 –
| Details | 2015 (In US $) | 2016 (In US $) |
| Common Equity | 300,000 | 400,000 |
| Preferred Stock @ 7% | 200,000 | 100,000 |
| Bond @ 8% | 300,000 | 200,000 |
We need to calculate the capital gearing ratio and would see whether the firm is high geared or low geared for the last 2 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 –
| Details | 2015 (In US $) | 2016 (In US $) |
| Preferred Stock @ 7% | 200,000 | 100,000 |
| Bond @ 8% | 300,000 | 200,000 |
| Total interest/dividend bearing funds | 500,000 | 300,000 |
Now we can calculate the capital gearing ratio for the last 2 years –
| Details | 2015 (In US $) | 2016 (In US $) |
| Common Equity (A) | 300,000 | 400,000 |
| Total interest/dividend bearing funds (B) | 500,000 | 300,000 |
| Capital Gearing Ratio (A/B) | 3:5 | 4:3 |
According to this ratio, we can easily say that in 2015, the firm was high geared. But later as the common equity increase in the year 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 of interest/dividend bearing funds, then the capital of the firm is highly geared and vice versa.
Example # 3
Let’s look at the information below furnished by F Corporation –
| Details | In US $ |
| Shareholders’ Equity | 840,000 |
| Preferred Stock | 160,000 |
| Bank Overdraft | 50,000 |
| Short term Debt | 600,000 |
| Long term Debt | 300,000 |
Calculate the capital gearing ratio for F Corporation.
Here, there is an interesting addition. We can see that a bank overdraft is being given. 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 borrower extra cash when he didn’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 case of this example –
| Details | In US $ |
| Preferred Stock | 160,000 |
| Bank Overdraft | 50,000 |
| Short term Debt | 600,000 |
| Long term Debt | 300,000 |
| Total Interest/Dividend bearing Funds | 11,10,000 |
Now, this ratio would be –
| Details | In US $ |
| Shareholders’ Equity | 840,000 |
| Interest/Dividend bearing Funds | 11,10,000 |
| Capital Gearing Ratio | 21:37 (High geared) |
In this case, as well, 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 gradually make the capital low geared.
Calculate Capital Gearing Ratio – Nestle Example
Below snapshot is Consolidated balance sheet of Nestle as of 31st December 2014 & 2015
source: Nestle
Calculation of Nestle’s total debt in 2015 and 2014 is as follows –
- 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
| In millions of CHF | 2015 | 2014 |
| Total Equity (1) | 63,986 | 71,884 |
| Total Debt (2) | 21,230 | 21,206 |
| Total Equity to Debt | 3.01x | 3.38x |
Capital Gearing ratio has decreased from 3.38x in 2014 to 3.01x in 2015. This Ratio decreased primarily due to the decrease in Equity contributed by buyback of treasury shares and also because of a decrease in translation reserves.
Capital Gearing Ratio – Oil & Gas Companies Case Study
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.
| Year | BP | Chevron | Noble Energy | Royal Dutch | Exxon Mobil |
| 2015 | 1.85 | 3.97 | 1.30 | 2.79 | 4.56 |
| 2014 | 2.14 | 5.59 | 1.70 | 3.78 | 6.07 |
| 2013 | 2.69 | 7.33 | 1.93 | 4.04 | 7.66 |
| 2012 | 2.43 | 11.29 | 2.03 | 4.63 | 14.33 |
| 2011 | 2.52 | 12.11 | 1.77 | 4.26 | 9.07 |
| 2010 | 2.10 | 9.39 | 3.01 | 3.34 | 9.78 |
| 2009 | 2.93 | 9.00 | 3.02 | 3.89 | 11.51 |
| 2008 | 2.75 | 10.12 | 2.78 | 5.47 | 11.99 |
| 2007 | 3.08 | 11.30 | 2.56 | 6.85 | 12.72 |
Data Source: ycharts
A common trend across all companies in the decrease of capital gearing ratio, especially after the year 2013. In 2013-2014, slowdown in commodity (oil) prices started and this is where most oil and gas companies got hit. These companies were unable to generate strong cash flows from operations and had to rely on debt as a source of funding thereby increasing its total debt. This increase in debt resulted in a decrease in ratio.
Investigating Pepsi’s decrease in Capital Gearing Ratio
Why do you think Pepsi’s Capital Gearing Ratio decreased?
Data source: ycharts
Capital Gearing Ratio can decrease because of three reasons –
- Increase in Debt
- Decrease in Equity
- Both (1) and (2), each contributing meaningfully.
Let us look at Pepsi’s Debt and Equity over the years in the graph below.
source: ycharts
We note that Debt has been steadily increased over the past 5 years period. In 2015, Pepsi’s debt was at $32.28 billion as 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’s 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 are those losses that have not been realized and may include items like forex gains/losses, unrealized gains/losses on securities, etc.
- Buyback of Shares that has resulted in an increase in Treasury stock. This buyback of shares resulted in a decrease in Shareholder’s Equity.
As we can see from above, the major contributing factor for the decrease in Capital Gearing Ratio of Pepsi was the sharp decrease in Shareholder’s Equity.
How companies reduce Capital Gearing Ratio?
There are usually four things a firm can do to reduce capital gearing. There are couple of reasons for which firms should reduce their capital gearing.
First, the firm needs to attract more investors by making it easy for them. 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 be difficult 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 of time, 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 often the most prudent way to reduce capital gearing are 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), then it would be easier for the firms 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 it will have its cash to pay off debts. But this is not a very good idea if a firm wants to stay in the business for a very long time.
Limitations
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 capital gearing ratio lies in whether the investment is risky or not. If the capital of the firm consists of more interest-bearing funds that mean it is a riskier investment to the investors. On the other hand, if the firm has more common equity, then the investors’ interest would be taken care of.
The only possible limitation of capital gearing ratio is this – this ratio is not the only ratio you should look at whenever you think to invest 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 of time. If yes, then it’s definitely a riskier investment. But if it’s not the scenario and they have borrowed some debt for their immediate need, then you can go ahead and think about investment (subject to the fact that you check other ratios of the company as well).
In the final analysis
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 risk just because it needs to invest in profitable projects; then you should think twice 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 taking any decision about the investment.
