Definition and Explanation:
It is the ratio between the capital plus
reserves i.e. equity and fixed cost bearing securities. Fixed cost bearing
securities include debentures, long term mortgage loans etc.
In a company form of organization, real risk is
borne by equity shareholders because they are entitled to whatever residue is
left after all others have been paid at the contracted rate.
This ratio measures the extent of
capitalization by the funds raised by the issue of fixed cost securities. This
ratio is interpreted by the use of two terms.
Highly geared mean lower proportion of equity.
Low geared means high proportion of equity as compared to fixed cost bearing
capital.
Formula:
The formula/equation for the calculation of
capital gearing ratio is as follows:
Capital gearing ratio = Equity /
Fixed cost bearings securities
Where,
Equity = Equity share capital +
Free reserves + Profits and loss account credit balance
Fixed cost bearing securities =
Debentures + Long term loans
Significance:
Capital gearing must be carefully planned.
Financial management gives us a concept of "Trading on Equity". It means as long
as rate of earnings of business is higher than cost of fixed interest/dividend
bearings securities the equity shareholders gain on the strength of their
equity. Reverse follows in alternative situations. |
