Example 1: The following information have been taken from

the balance sheet of PQR limited:

The following information has been taken from
the balance sheet of L & M company. Year 2011:

Common stockholders’ equity: $3,500,000

 8%Bonds payable: $800,000
 12%Preferred stock: $700,000
Preferred stock – 9%: $1,400,000
 Common stockholders’ equity: $2,000,000
Required: Compute capital gearing ratio of L &
M company. Bonds payable – 6%: $1,600,000
Solution:
Year 2012:
Capital gearing ratio = Common stockholders’
equity/Fixed cost bearing funds Common stockholders’ equity: $2,800,000

Preferred stock – 9%: $1,800,000

= $2,000,000/$1,500,000*
4 : 3 (Low geared) Bonds payable – 6%: $1,400,000

*$800,000 + $700,000
The L & M company has a low geared capital
structured because common stockholders’ equity
is more than the fixed cost bearing funds (total of
preferred stock and bonds). For every $4
contributed by common stockholders, there are
only $3 contributed by fixed cost bearing funds.
We can compute the capital gearing ratio for the
years 2011 and 2012 from the above information
as follows:
For the year 2011:
Capital gearing ratio = 3,500,000 / 3,000,000

Example 2 = 7  :  6 (Low geared)

The R & G company’s balance sheet as on For the year 2012:

December 31, 2017 shows total long term debts
of $500,000, total preferred share capital of Capital gearing ratio = 2,800,000 / 3,200,000
$300,000 and total common share capital of
$400,000. Calculate capital gearing ratio of R & G = 7 : 8 (Highly geared)
company. Also interpret the capital structure of
the company. The company has a low geared capital structure
in 2011 and highly geared capital structure in
2012.
Capital gearing ratio = $400,000 : $800,000

Notice that the gearing is inverse to the common

1:2 stockholders’ equity.

The capital gearing ratio is 2 : 1 which means the  Highly geared >>> Less common
company is highly geared. For every $1 invested stockholders’ equity
by the common stockholders, there is an  Low geared >>> More common
investment of $ of preferred stockholders and stockholders’ equity
loan providers.

A company with highly geared capital structure

will have to pay high fixed interest costs on long
term loans and more dividend on preferred stock
and will have to face difficulty in attracting new
investors.

Example: