Calculating the Gearing Ratio
This solution explains how to calculate the gearing ratio based on the provided financial figures. The gearing ratio is a financial metric used to measure a company's financial leverage. It indicates the proportion of a company's capital that comes from debt compared to equity.
Understanding the Gearing Ratio Components
To calculate the gearing ratio, we need to identify the relevant components from the given data:
- Debt Capital: This typically includes long-term interest-bearing liabilities. In this case, 'Debenture' ($1,00,000$) is the primary component. Preference Share Capital ($1,00,000$) is often treated as a form of debt in gearing calculations because it carries a fixed dividend, similar to interest on debt.
- Equity Capital: This represents the owners' stake in the company. 'Equity Share Capital' ($200,000$) is the main component here.
- Irrelevant Items: Items like 'Cash balance' ($20,000$), 'Creditors' ($90,000$) (usually considered operational liabilities), and 'Fixed Asset' ($2,00,000$) are generally not included in the standard gearing ratio calculation.
Relevant Financial Data
Let's list the values needed for the calculation:
| Item | Value (INR) | Relevance for Gearing Ratio |
|---|---|---|
| Preference Share Capital | 1,00,000 | Included (treated as debt-like) |
| Cash balance | 20,000 | Excluded (Asset) |
| Debenture | 1,00,000 | Included (Debt) |
| Creditors | 90,000 | Excluded (Operational Liability) |
| Equity Share Capital | 200,000 | Included (Equity) |
| Fixed Asset | 2,00,000 | Excluded (Asset) |
Step-by-Step Gearing Ratio Calculation
A common way to calculate the gearing ratio is:
$ \text{Gearing Ratio} = \frac{\text{Debt Capital} + \text{Preference Share Capital}}{\text{Equity Share Capital}} $
Step 1: Identify Debt Capital and Preference Share Capital.
- Debenture = $1,00,000$
- Preference Share Capital = $1,00,000$
- Total Debt Component = Debenture + Preference Share Capital = $1,00,000 + 1,00,000 = 2,00,000$
Step 2: Identify Equity Share Capital.
- Equity Share Capital = $200,000$
Step 3: Calculate the Gearing Ratio.
Plug the values into the formula:
$ \text{Gearing Ratio} = \frac{2,00,000}{200,000} $
$ \text{Gearing Ratio} = 1 $
This ratio indicates that the company's debt-like capital (Debentures + Preference Shares) is equal to its Equity Share Capital. A gearing ratio of 1 means the company is financed equally by debt (including preference shares) and equity.
Important Questions from Ratio analysis
Net profit after taxes of a firm is Rs.1,00,000 and its fixed interest charges on long term debt are Rs. 20,000. What is the interest coverage ratio if the rate of income tax is 60%?
Match the items in Column – I with the items in Column – II and indicate the correct code :
Column – I Column – II a. Debt-Equity Ratio i. Net Profit before interest and tax
$\div Interest on long term loans$b. Proprietary Ratio ii. Equity share capital + Reserves
$\div Preference share capital + Interest bearing finance$c. Interest coverage ratio iii. Long term debts
$\div Shareholder's Funds $d. Capital gearing ratio iv. Shareholder's Funds
$\div Total Assets $
Codes:A company sold 20% of the goods on cash basis and balance on credit basis. Debtors are allowed \(1\frac{1}{2}\) months’ credit and their balances as on 31st March, 2023 is Rs. 1,25,000. Assume that the sale is uniform throughout the year. Credit sales would be
The amount of closing stock would be, when
Sales - Rs. 6,00,000
Opening Stock - Rs. 50,000
Purchases - Rs. 5,00,000
Productive Wages - Rs. 10,000
Carriage Inwards - Rs. 7,000
Rate of Gross Profit on cost - 20%
Match List–I with List–II :
List I
(Useful ratio)
List II
(Symptom)
(a)
Finished goods turnover ratio (i)
Liquidity crisis (b)
Interest coverage ratio (ii)
Inability to pay dues to financial institutions (c)
Debt-service coverage ratio (iii)
Inability to pay interest (d)
Current ratio and quick ratio (iv)
Falling demand for the product in the market
Select the correct answer using the codes given below.
