Managers, creditors and investors are keenly interested in a company's financial structure. How a company chooses to finance expansion and operations can have a strong effect on its potential for success. Gearing ratios hone in on this aspect of a company by measuring company debt, interest expense and equity. Some of the most common gearing ratios are debt-to-equity, interest coverage, the debt ratio and the equity ratio.
The debt-to-equity gearing ratio is a comprehensive formula that considers all types of business liabilities relative to equity. The debt-to-equity ratio is all liabilities, including long-term debt, short-term debt and other liabilities, divided by shareholder's equity. For example, say that a company has $400,000 in long-term loans, $100,000 in short-term loans, other liabilities of $20,000 and shareholder's equity equals $700,000. Total debt equals $520,000 and the gearing ratio is 74 percent ($520,000 over $700,000). The higher the number, the harder it is for the business to pay down its debt.
Interest Coverage Ratio
The interest coverage ratio, also known as the "times interest earned ratio," measures how easily a company can meet its interest payments. The interest coverage ratio is earnings before interest and taxes -- EBITA, for short -- divided by interest expense for the period. For example, a company with an EBITA of $60,000 and interest expense of $6,000 has an interest coverage ratio of 10. In other words, they can pay interest expense with earnings 10 times over. The higher the ratio is, the better the company can pay interest expense on existing debt.
A company often takes on financing to purchase additional buildings, property and equipment. The debt ratio compares assets and liabilities to measure how much debt a company has relative to assets. The debt ratio formula is total liabilities, both long-term and short-term, divided by total assets, both long-term and short-term. If a company has total liabilities of $50,000 and total assets of $60,000, its debt ratio is 83 percent. A low debt ratio means that the company doesn't take out much debt and has a lower risk of defaulting on payments.
Creditors prefer to lend to companies with high equity financing because there's lots of opportunity to pay down debt. The equity ratio is a measure of capital structure that measures equity relative to total assets. The formula for the equity ratio is shareholder's equity divided by total assets. A company with $40,000 in equity and $80,000 in total assets has an equity ratio of 0.5. That means that half of the company is financed by equity and the other half is financed by debt. The higher this ratio is, the easier it tends to be for the company to get financing.
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