Gearing - Debt-to-Equity Ratio

What it measures: Solvency 

How a firm has financed its asset purchases; 

Proportion of equity and debt in the financing of business operations;

Capital structure; ability of firm to meet financial commitments in long-term.

Information drawn from the Balance Sheet.

Represented as a ratio AND / OR a percentage (2.11 : 1 OR 211%)

The equation:

Total Liabilities / Owner’s Equity (x 100)

What the result means:

For every $1 of Owners’ Equity, the firm has $_____ of debt (total liabilities). Firms that have a higher result means that they use more debt to finance their operations; highly geared, highly leveraged. 

The higher the proportion of debt in a firm, the higher the potential profitability for the owners (see Return on Equity ratio) but the greater the risk of insolvency. If the result is below 100%, this means the firm could be making more use of debt to improve firm growth / performance. Debt is good - so long as it can be serviced.

For this course - the benchmark of 100% or 1:1 is ideal from an SME.

Sample Statement:

Total Liabilities ($300,000) / Owner’s Equity ($95,000) = 3.15 : 1     or 315%

The firm has a gearing ratio of 3.15 : 1; or 315%. This means that for every $1 of Owner’s Equity to finance the firms assets, it uses $3.15 of debt. This firm is fairly highly geared; increasing the possibility of profits but also the risk of long-term instability. Depending upon forecasts for revenue from firm activity, they may want to take measures to reduce exposure to debt. 

Activity: 

Calculate the Debt to Equity Ratio in the three Options below. 

Note: The assets do not change. That is - what the business is using to operate remains exactly the same. The only thing that changes with each option is WHERE the firm seeks the finance to buy those assets. The capital structure changes. 

How a firm chooses to finance their asset purchases will affect their solvency. 

Firms that use more debt in relation to equity are more highly geared / highly leveraged and thus have a greater risk of solvency issues.

Ways to improve the Debt to Equity ratio if too low (less than 100% is too risk averse):

• Acquire a non-current loan and pay out some Owner's Equity back to owners.

• Only utilise debt for future growth plans

Ways to improve the Debt to Equity ratio if too high (too highly geared):

• Stabilise the firm with equity injections from existing owners or new shareholders - use these funds to pay down debt

• Only use equity financing for any future growth plans.

• Use leasing to acquire new capital assets - rather than owning them outright by using debt to finance ownership

• Use sale and lease-back strategy. if the firm purchased assets outright using debt to finance the purchase, sell the asset and lease is back. use the cash proceeds to pay down non-current debt.