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Gearing ratios (Debt to equity (Debt / equity, Measures debt to equity by…
Gearing ratios
Debt to equity
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When comparing companies of similar nature and in the same industry, a low debt to equity ratio indicates less risk
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Measure the solvency of a company and focus on the extent to which businesses use long term debt financing compared with equity financing
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The various gearing ratios indicate the ability of a business to fund its debt and interest payments for its continuing operations
A company that is highly geared or leavers has a high proportion of debt to equity whereas a company with a low gearing ratio has a relatively low level of debt compared with equity
A highly geared company might be considered more risky than a company without gearing because the highly geared company will have regular interest payments to service the debt and in times of increasing interest rates, businesses with high levels of borrowing with variable rate interest payments may find themselves faced with uncomfortably large monthly outgoings in order to service the debt
A company that is funded only by equity will have no interest payments. Instead it will pay out a dividend to the owners of the company but only if it can afford to do so. Dividends are paid out at the discretion of the directors whilst interest payments on long term debt financing are a contractual payment
Whilst equity may be less risky than debt it may prove more costly to service. In particular, interest payments on debt are tax deductible for the issuing entity whereas dividends on equity are not.
Lenders are particularly interest in a company's gearing ratios since a high gearing ratio might indicate a company's inability to repay debt. It is not unusual for lenders to restrict a company's level of gearing through the use of loan covenants