THE GEARING RATIO
Gearing (or leverage) is a measure of a business's long-term financing arrangements (or capital structure). It is essentially the proportion of a business financed via debt compared to equity.
Gearing ratio = (Interest bearing debt - Cash) / [Equity + (Interest bearing debt - Cash)]
The ideal proportion is subject to the nature of a business and the current economic climate. In practice many businesses have gearing levels less than 50%. The higher the gearing, the greater the risks from dilution of earnings and sensitivity to changes in interest rates.
THE DEBT RATIO
This measures the ability of a business to meet its debts in the long term. It is a measure of 'security' for financiers. The ratio should certainly be less than 100% and many believe it should be less than 50%.
Debt ratio = Total debts (current and non-current liabilities) / Total assets (current and non-current assets)
The risk posed from high debt and gearing ratios can be mitigated by high interest cover.
INTEREST COVER
This measures how many times a business can pay its interest charges (or finance expenses) from its operating profit (or profit before interest and tax). Ideally a business should be able to cover its interest at least 2 or more times.
Interest cover (times) = Operating profit (EBIT) / Finance expenses
The ability to service debt is a measure of risk to debt providers, shareholders and ultimately the business itself.
NET DEBT TO EBITDA
Although not a traditional measure of long-term solvency, the 'net debt to EBITDA' ratio has become increasingly popular with banks as a measure of gearing. (EBITDA stands for 'earnings before interest, taxes, depreciation and amortization'.)
Net debt to EBITDA (times) = (Interest bearing debt - Cash) / EBITDA
Banks will typically lend a business up to 5 times its earnings. Cash generated from operations can be substituted for EBITDA.
Use gearing and debt ratios to calculate long-term risk levels.
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