What is Capital Gearing Ratio?
In this resource, we will understand the Gearing ratio, specifically the Capital Gearing ratio. We will learn how to calculate it, know its importance and drawbacks. Also, in the later section, we will compare how different is the ratio for companies in various sectors
As part of business operation companies fund their Assets either by Equity Capital or Debt Capital. Equity Capital is nothing but the Capital contributed by the Equity shareholders. Debt Capital is nothing but the amount lent by the Lenders ( Financial Institutions or Bond Holders).
To understand the Capital structure of the company, we need to study Solvency ratios like the Debt to Equity ratio or Debt to Capital ratio. Apart from these ratios, we can also look at Capital Gearing Ratio to get a clear picture.
Gearing ratios try to analyze the Capital Structure of the company. They explains if the Debt level of the company is high or low.
Capital Gearing Ratio meaning
Gearing, in its simplest sense, means the level of Debt utilization as part of Business Operations.
If the Debt is relatively higher, it means “Highly Geared”.
Such a situation may pose serious Solvency issues. It may even result in Bankruptcy of the company if not mitigated on time.
Hence, management constantly aims to maintain reasonable Debt level on its Balance Sheet with out posing any impact to the profitability.
Gearing is measured by the use of a ‘Gearing Ratio’, which is calculated by dividing the Total Equity by Debt.
Capital Gearing ratio tries to build relationship between the companies Equity Capital and Fixed Interest bearing Capital.
Formula for Capital Gearing Ratio
The formula of the Capital Gearing ratio is very simple.
- We take total Equity Capital in the numerator
- Total Fixed Interest bearing Capital in the denominator
As explained in Debt to Equity ratio resource, Total Equity Capital includes various Balance Sheet items. Below are the items that are generally part of Total Equity
- Common Stock
- Treasury stock
- Securities premium
- Minority Interest
- Other Comprehensive Income (OCI)
- Retained earnings
Fixed Interest-bearing Capital
- Fixed Interest bearing Capital is nothing but the Borrowings of the company.
- Both short-term and long-term Debt has to be considered.
- Other liabilities that are not in the Interest bearing form has to be excluded as part of the calculation.
Let us look at our first example to understand the ratio better.
How to calculate Captial Gearing Ratio – Example
Consider two companies- Alpha Inc. and Beta Inc. that are in the same industry.
The Balance Sheet extract for both the companies is given below. The values given are in $ million.
Let us calculate the ratio for both the companies one by one.
To calculate the Capital Gearing ratio, we need
- Total Equity
- Fixed Interest bearing Capital
Both the values can be obtained from the Balance Sheet.
As evident in the image above, the components of Total Equity are
- Common Stock
- Retained Earnings
- Other Equity
Alpha Inc. = Common Stock + Retained Earnings + Other Equity
= $100 + $20 + $80 = $200
Beta Inc. = Common Stock + Retained Earnings + Other Equity
= $100 + $300 + $300 = $700
Fixed Interest bearing Capital
In the given example both the companies have only two items that constitutes Fixed Interest bearing Debt.
- Short term Debt
- Long term Debt
Alpha Inc. = Short term Debt + Long term Debt
= $120 + $300 = $420
Beta Inc. = Short term Debt + Long term Debt
= $20 + $100 = $120
As shown in the image above Fixed Interest bearing Capital forms a significant part of the Capital structure of Alpha Inc.
On the contrary, Beta Inc. funds significant of its Capital via Equity.
Capital Gearing ratio = Total Equity / Fixed Interest bearing Capital
Alpha Inc. = $200 / $420 = 0.48 times
Beta Inc. = $2,700 / $120 = 5.83 times
0.48 times Capital Gearing ratio in the case of Alpha Inc. indicates that the company has a relatively low Equity Capital compared to Debt Capital.
This indicates high gearing.
On the contrary, 5.83 times Capital Gearing ratio of Beta Inc. indicates significant amount of Equity forms part of the company’s Capital structure.
It clearly shows that the company is not highly geared ( Debt Capital is low compared with Equity Capital )
Nonetheless, Alpha Inc. is prone to more risk compared to Beta Inc. As the company is highly geared with Debt Capital, the company may have to pay Interest expense even if the Revenue suffers.
Having high Debt Capital relative to Equity in itself is not to be concluded as bad since the company might be strategically leveraging on Debt Capital to earn a higher Return on Equity to its Equity shareholders.
Capital Gearing Ratio Excel template – Walmart Inc case study.
In our next example, let us calculate the Capital Gearing ratio using excel.
You can download the template using the below option
Once you download the template, you would see the consolidated Balance Sheet of Walmart. We will focus on the year ending 31 Jan 2020.
Walmart is the US-based retail company.
We need a Total Equity and Total fixed Interest bearing Capital for our calculation.
If we look at the Equity section of the Balance Sheet, we can see that the company has various components.
Let us add all of these items to arrive at total Equity .
Total Equity = Common stock + Additional paid-in Capital + Retained earnings + Other Equity + Minority Interest
= $2,284 + $3,247 + $ 83,943 – $12,805 – $6,883
Fixed Interest Bearing Capital
As evident from the Balance Sheet above, company has 2 form of Debt Capital.
Fixed Interest bearing Capital = Short term Debt + Long term Debt
= $575 + $43,714 = $44,289
Now that we have both the values, let us calculate the ratio using Excel.
Capital Gearing ratio = Total Equity / Fixed Interest bearing Capital
= $81,552 / $44,289
= 1.84 times
What does Capital Gearing ratio of 1.84 indicates?
It indicates that for each dollar of Interest-bearing Debt, the company has $1.84 worth of Equity.
This indicates that Equity forms significant part of the company’s Capital structure.
Hence we can conclude the company is not highly geared.
How to Interpret Capital Gearing Ratio
As already discussed, this ratio tries to build relationship between company’s’ Equity Capital to Debt Capital.
Building the Capital structure with significant Debt Capital or Equity Capital has always been an important decision to be made by the management.
If the company has access to cheap Debt Capital and has a good Interest coverage ratio, it generally prefers having high Debt relative to Equity Capital. This also results in a higher Return on Equity (since the Equity base is will be relatively lower)
If the ratio is significantly higher, it means that Equity Capital is more than Debt Capital. Hence, Low Gearing.
On the contrary, if the ratio is lower, it means that the Equity Capital is insufficient as against Debt Capital. This will indicate that a significant amount of the company’s Capital structure is funded via Debt – Hence, Highly Geared
Although Highly Gearing means a significant amount of Capital is funded by Debt, it may also suggest that the Equity base is relatively low and if the company is operationally profitable and has good cost control measures in place then invariably it gives improved return ratios for shareholders
High Capital Gearing means high Debt Capital. This can prove determinantal in case the company has a very low interest coverage ratio. As a result of which most of your Operating Profit margin may be seriously impacted.
How to improve Capital Gearing Ratio
Clearly, as we understood the ratio tries to build relationship between Equity Capital and Debt Capital.
If we want to improve the Capital Gearing ratio- it is nothing but improving the Highly Geared situation (Bringing Debt level and Equity level to a favourable position)
Capital Gearing can be improved in many ways. Few are listed below
Increase Sales volume or Sales Price
If the company has pricing power and competitive advantage, it can further try to raise the Sales Price or try to increase the Sales Volume such that it provides incremental Profits.
Such profits can be utilized to pay off the Debt.
Implement robust cost control measures
If the company can control its cost in the most efficient manner, that invariably adds to the profits. Hence, such incremental profit can be further utilized in paying off Debt
Utilize Cash Balance
If the company has sufficient amount of Cash on its Balance Sheet, it would be prudent to utilize such Cash towards paying off its Debt.
Capital Gearing Ratio Case Study 1: Google Inc.
In this case study we look at the Capital Gearing ratio for Google Inc. for the past 5 years and try to understand how the ratio can take shape in case of Low Debt companies
As evident from the chart above, the Gearing ratio for Google is significantly high.
If we recall the formula,
Capital Gearing ratio = Total Equity / Fixed Interest bearing Capital
Company like Google literally has very nominal Fixed Interest bearing Capital on its Balance Sheet. Hence the ratio appears to be numerically high.
For example during 2015 the ratio was 20x. This means for each dollar of Debt Capital, the company already had $20 worth of Equity Capital.
A growth company like Google never paid any dividend to its Equity shareholders. Most of its profits are ploughed back into the business.
Over the past five years, the company continued performing operationally exceptional. As a result of which the Equity base kept on increasing.
Every year the company made profits (with no Debt on its Balance Sheet). The numerator kept on increasing while the denominator was stagnant.
Hence, as evident from the chart above the Capital Gearing ratio kept on increasing i.e, the share of Equity Capital relative to Debt Capital became higher and higher.
Capital Gearing Ratio Case Study 2: Home Depot.
Let us look at another example of a US-based home improvement company – Home Depot.
During 2015, the Capital Gearing ratio of Home Depot was 0.54 times. This indicates that for each dollar of Debt, the company had only $0.54 of Equity Capital.
Meanwhile, the company continued buyback of its Equity shares and this resulted in fall of its Equity base.
On paying close attention to the Equity Schedule, we can see that value of Treasury Stock (Shares that are bought back as part of the Buy-Back program) is negative. As a result of which even Total Equity is negative.
Because of all these events, the Gearing ratio for the company has turned into negative.
Home depot is among the very few companies where the Equity base is negative resulting in an unusual trend in Gearing ratio.
In the next few sections, let us explore the Capital Gearing ratio for various companies. This will help us in understanding how different is the Capital structure of companies in different industries.
We have already calculated the Capital Gearing ratio for Walmart as part of the example above.
The company has high Equity compared to Debt resulting in the ratio more than 1.
Clearly this suggests the company is not highly geared.
For the year ending 2019, the Gearing ratio for Walmart is 1.37 times. What this indicates is that for each dollar of Fixed Interest bearing Capital, the company has $1.3 of Equity Capital.
Similarly, another US-based company Amazon Inc. has a Capital Gearing ratio of more than 1, which suggests that the company has sufficient Equity Capital relative to the Debt.
During 2015 the ratio was 0.67 times. Over the past few years, the company was able to reduce Debt Capital and increase Equity base. This resulted in an increased gearing ratio.
During 2019 the ratio was 0.8 times.
Home Depot Inc.
As evident from the graph above, Home Depot has a peculiar gearing profile.
We discussed this aspect in-depth as part of the case study. Because of a series of Buybacks, the company was trying to reduce its Equity base.
Although, the Debt of the company has increased marginally, the decrease in Equity base is very strong that the Gearing ratio is decreasing
For the year ending 2019, the company has negative Capital Gearing ratio of -0.06 times
US-based Search Engine giant Google has a relatively higher Capital Gearing ratio.
This indicates that the company has significant amount of Equity Capital relative to its Fixed Interest bearing Capital.
We saw in our detailed case study that how Google has nominal Debt Capital relative to its high Equity base. Hence, the company has ever-increasing Capital Gearing ratio.
It is important to note that for the year ending 2019, the Capital Gearing ratio of Google was as high as 45 times. This indicates that the company has $45 worth of Equity Capital for each dollar of Debt Capital (that is to say that the company is almost not geared at all.)
Although not clearly visible in the chart above, Apple has a gearing ratio which of more than 1.
For the year ending 2015, the company had $1.86 of Equity Capital for each dollar of Fixed Interest bearing Capital.
Over the past few years, the company’s Debt has been increasing relative to its Equity Capital. Hence the ratio has been falling.
For the year ending 2019, the ratio is 0.8 times.
Similar to Apple, even Microsoft has a Capital Gearing ratio that is more than 1. This indicates that the company has sufficient Equity Capital as against fixed Interest bearing Capital.
Back in 2015, the company had $2.7 Equity for each dollar of Debt.
Over the past few years the Debt has marginally increased relative to Equity. Currently in 2019, the Capital Gearing ratio for Microsoft is 1.3 times.
In the case of US-based auto maker Tesla, the ratio is less than 1.
Over the past few years, Tesla has been burning cash at a significantly higher rate. Even though the company’s losses are piling up, it manages to raise Capital from new investors and keep the company floated.
The Capital Gearing ratio of 0.37 in 2015 clearly indicated the insufficient Equity relative to Debt Capital.
For the year ending 2019, the Capital Gearing ratio is 0.41 times.
Johnson and Johnson
We move our focus towards US-based Pharmaceutical, medical instrument maker Johnson & Johnson.
Back in 2015, the company had $3.8 Equity for each dollar of Debt Capital.
Similar to what we have seen in the case of Home Depot, even this company performs periodic Buy-back resulting in negative Treasury stock. As a result of this invariably the Equity Capital has been decreasing over the past few years.
It is important to note that the ratio has Fallen not because of increase in Debt but because of decrease in the Equity.
For the year ending 2019, the Capital Gearing ratio for Johnson and Johnson was 2.15 times
The Capital Gearing ratio in the case of US-based Oil Company ExxonMobil is relatively higher.
The ratio was 5.9 times back in 2015 which decreased to 3.9 times during 2017. Subsequently, it again increased to 2.07 times in 2019.
The company has a Capital Gearing ratio of more than 1 which indicates that the company has a sufficient Equity base compared to its Fixed Interest Capital.
Over the past few years, the company has been suffering losses. Evaluating the company solely on gearing ratios would be inappropriate.
Hence one must look at the whole picture before making any decision.
Relatively higher Capital Gearing ratio depicted in the chart above is of US-based global payment platform provider PayPal.
During 2015 and 2016 the company literally has no Debt on its Balance Sheet. Only since 2017, we can see a marginal Debt. Hence, suddenly the ratio appeared significantly high in 2017
During the year ending 2018 the ratio was almost 7.7 which the company managed to decrease to 3.3 times in 2019.
This has been the most detailed explanation about Capital Gearing ratio.
One must keep in mind that having a high Capital Gearing ratio or low ratio in itself will not mean good or bad. It always has to be gauged with other solvency ratios to get a complete picture.
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