Capital Gearing Ratio

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.

The 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 that are low geared tend to pay less interest 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.

Oil & Gas Companies - Capital Gearing Ratio

Also, have a look at Capitalization RatioCapitalization RatioCapitalization ratios are a set of ratios that assist analysts in determining how a company's capital structure will affect if an investment is made in the company. The debt-to-equity, long-term debt-to-market-cap, and total debt-to-market-cap ratios are all included.read more

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.

Capital Gearing Ratio

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For eg:
Source: Capital Gearing Ratio (wallstreetmojo.com)

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 leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more 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 equityTrading On EquityEquity trading refers to the corporate action in which a company raises more debt to boost the return on investment for equity shareholders. This financial leverage process is considered a success if the company can earn a more significant ROI.read more“. 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 a 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 –

DetailsIn US $
Shareholders’ Equity300,000
Short term Debt200,000
Long term DebtTerm DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more300,000


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.

DetailsIn US $
Short term Debt (1)200,000
Long term DebtTerm DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more (2)300,000
Funds bearing interest (1+2)500,000

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

DetailsIn US $
Shareholders’ Equity (3)300,000
Funds bearing interest (4)500,000
Capital Gearing Ratio3:5 (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 –

Details2015 (In US $)2016 (In US $)
Common Equity300,000400,000
Preferred Stock @ 7%200,000100,000
Bond @ 8%300,000200,000


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 –

Details2015 (In US $)2016 (In US $)
Preferred Stock @ 7%200,000100,000
Bond @ 8%300,000200,000
Total interest/dividend bearing funds500,000300,000

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

Details2015 (In US $)2016 (In US $)
Common Equity (A)300,000400,000
Total interest/dividend bearing funds (B)500,000300,000
Capital Gearing Ratio (A/B)3:54:3

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 –

DetailsIn US $
Shareholders’ Equity840,000
Preferred Stock160,000
Bank OverdraftBank OverdraftOverdraft is a banking facility that offers short-term credit to the account holders by allowing them to withdraw money from their savings or current account even if their account balance is or below zero. Its authorized limit differs from customer to customer.read more50,000
Short term Debt600,000
Long term Debt300,000

 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 extra borrower 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 –

DetailsIn US $
Preferred Stock160,000
Bank Overdraft50,000
Short term Debt600,000
Long term Debt300,000
Total Interest/Dividend bearing Funds11,10,000

Now, this ratio would be –

DetailsIn US $
Shareholders’ Equity840,000
Interest/Dividend bearing Funds11,10,000
Capital Gearing Ratio21:37 (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 make the capital low geared gradually.

Calculate Capital Gearing Ratio – Nestle Example

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

Nestle Capitalization Ratio

source: Nestle

Calculation of Nestle’s total debt in 2015 and 2014 is as follows –

Calculating Capital Gearing Ratio
In millions of CHF 2015 2014
 Total Equity (1)63,98671,884
Total Debt (2)21,23021,206
Total Equity to Debt 3.01x 3.38x

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 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.

Oil & Gas Companies - Capital Gearing Ratio

Data source: ycharts

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

YearBPChevronNoble EnergyRoyal DutchExxon 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, a 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 operationsCash Flows From OperationsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more 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?

Pepsi Equity Debt

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), each contributing meaningfully.

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

Pepsi-Capital-Gearing-Debt-and-Equity

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.

Pepsi Capital Gearing 1

source: Pepsi SEC Filings

We note that two items have contributed to 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 a 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 –

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 means 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.

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

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 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 making any decision about the investment.

Capital Gearing Ratio Video

 

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Comments

  1. Peace Amana says

    These explanations are very educating.
    Thumbs up WallStreetMojo

    • Dheeraj Vaidya says

      Thanks for your kind words!