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How does Capital Gearing differ from Income Gearing?
Capital gearing and income gearing differ in the sense of their application, as the calculation of the two are different from each other. The measures of financial leverage, namely debt ratio and debt-equity ratio are related to capital gearing; whereas the interest coverage ratio is a measure of income gearing.
Capital gearing measures are static in nature. Therefore, they are incapable of stating the financial risks an investor or a company may face in the long term.
It also does not represent the true condition of a company’s financials and hence misses to report the repayments or payments of interests.
There is a third ratio known as the coverage ratio that indicates the capacity of a company to meet its debts or repayments.
This ratio tells whether a company would be able to meet its fixed financial charges over a longer period of time.
This ratio is reciprocal of the coverage ratio which is interest divided by EBIDTA is a measure of a company’s income gearing.
By comparing the coverage ratio with the accepted market standards, investors can check the risks associated with an investment project.
Limitations of Coverage Ratio
The coverage ratio, however, has some limitations.
It is usually cash flow that offers an insight into the ability of a company to meet its fixed repayment needs, not the reported earnings. During recessions, there can be a huge disparity between cash flows and earnings.
The second disadvantage is that when the ratio is calculated depending on past records, it fails to predict the future perfectly. Therefore, the coverage ratio cannot be used to calculate the risks with optimum efficiency. This disadvantage is common among firms, as future earnings can hardly be calculated by data obtained from the past. Even if the data is used assuming the best possible alternatives to calculate future situations, it is impossible to correctly estimate the future conditions.
The third disadvantage is that it is just a short-term liquidity ratio, not of financial leverage. This means that the coverage ratio can be used to calculate the short-term liquidity, but it is incapable of representing the financial leverage it offers to the business.
These drawbacks make the coverage ratio an indifferent measure of calculating the financial leverage.
Income gearing is different from capital gearing in more than one ways. Capital gearing is more about the debt, while income gearing is usually about the net income a company generates within a limited time.
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