Components

• The two components of the gearing ratio are equity and debt. Equity share capital is the value of all of the shareholder ownership. It includes surpluses and reserves, such as options. This value is considered the market value of the firm. Debt includes long-term loans that cannot be quickly returned to cash.
  
  

Calculation

• The calculation for gearing ratio is as follows:
  
  capital gearing ratio = equity share capital / fixed interest bearing funds
  
  For example:
  
  Equity share capital = $200,000
  
  Surpluses = $100,000
  
  Long-term loans = $150,000
  
  Gearing ratio: (200,000 + 100,000) / 150,000 = 2
  
  

Significance

• The gearing ratio can be used by analysts to determine how healthy a corporation is. A gearing ratio above 1.0 is considered healthy, while less than 1 is less robust. Many technology companies with zero debt have infinite gearing ratios. At the same time, manufacturing firms that use a lot of capital expenditures and loans to generate new businesses have much lower gearing ratios.
  
  

Valuation

• Analysts can use gearing ratios as a mechanism to compare different companies and make investment decisions. For example, two firms in the automobile industry have similar valuations and similar profit margins. However, one firm has a much higher gearing ratio. Financial analysts would be likely to recommend investing in the firm with the higher ratio.