The debt to equity ratio is also known as the net gearing ratio. It is a type of leverage ratio that helps show how leveraged a company is. Investors and creditors often use this. The purpose is to see what ratio of equity and debt are used to fund the business. The more debt used increases the debt to equity ratio, thus signifying a highly leveraged business. Lenders see highly leveraged organizations as risky. Because if there are other debt obligations, the company is less likely to repay the lender. Investors understand highly geared (highly leveraged) companies to be more vulnerable to a slow in sales. If sales decrease, the debt service payments could be too high to pay off.
A highly leveraged company can be a riskier investment, because it will always have to service its debt. A low leveraged business uses more of the owner’s or business’s investment than outside investment. This avoids high debt payments that could halt a company’s cash flow during a downturn in sales. A highly geared business may be riskier, but it will also have more capital to expand and be profitable.
The debt to equity formula or equation is (debt/equity.) Many different sources use their own version of the ratio, but debt/equity is the simplest form. Some people prefer to use long term debt in the numerator in order to get a better idea of the risk of long term debt repayment. Whereas, others think this is a skewed view since it does not take short term debt into consideration. It varies by what types of debt the business has and what the investor is looking for.
Looking at the debt to equity formula does not tell the whole story. When considering businesses in different industries, it is important to decide which formula to use. Some industries are at a greater risk of long term debt or short term debt. When comparing these leverage ratios, it is a good idea to compute the basic debt/equity formula as well.
The internet, trade associations, and research firms have plentiful information on leverage ratios across different industries. This makes it possible to compare one business’s debt to equity ratio against others of similar size. University libraries usually have numerous subscriptions that give this information. They have comparisons across numerous different ratios, sizes, and industries. Interns from these universities have full access to these databases. Another option to gain access to these databases is by paying for access. It is often expensive and risky whether one service will be able to provide each statistic needed. This is why large corporations and universities subscribe to numerous services for the same information.
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