Financial ratios are useful tools that help business managers and investors analyze and compare financial relationships between the accounts on the company’s financial statements. In other words, It measures the relationship between two or more components of financial statements.
In my previous post on this topic, I shared the importance of ratio analysis and the types of ratios.
We will take a further look at two other financial ratio categories that we use to assess business performance in this post.
LEVERAGE RATIO
The leverage ratio measures the ability of a firm to meet its long-term obligation. This is unlike the liquidity ratio that checks the ability of a firm to meet its short-term obligations.
The leverage ratio can also be referred to as the stability ratio or long-term solvency ratio.
It measures the ability of the firm to pay its maturing long-term debt.
Furthermore, this ratio looks at how much capital comes in the form of debt (loans). The leverage ratio category is important because companies rely on a mixture of equity and debt to finance their operations,
Therefore, this ratio is useful in evaluating whether a company can pay off its debts as they come due.
We will be discussing two of the common leverage ratios below.
- Debt ratio
- Gearing ratio
DEBT RATIO
The Debt to Asset Ratio, also known as the debt ratio, is a leverage ratio that indicates the percentage of assets that are being financed with debt.
A company’s debt ratio can reveal information about its capital structure and provides insight into the company’s leverage.
The more leveraged a business is, the more it relies on its lenders for continued solvency. This also indicates high exposure of the company to financial risk.
The formula for calculating the Debt ratio is:
Debt 𝑟𝑎𝑡𝑖𝑜= Total debts/Total assets
So, if a business reports a debt ratio that is greater than one, this means it has more debt than assets. If the ratio is less than one, the business has more assets than it does debt.
GEARING RATIO
The gearing ratio measures the proportion of a company’s borrowed funds to its equity. It shows the level of the business’s exposure to financial risk since excessive debt can lead to financial difficulties.
The gearing ratio is also known as the debt to equity ratio.
This ratio determines to what degree a company’s actions are funded by shareholder equity in comparison with creditors’ funds.
In addition, the gearing ratio provides clarity into the sourcing of a company’s operation funding. Thus, providing greater insight into the company’s reliability and whether they are able to withstand periods of financial scarcity.
The formula for calculating the gearing ratio is:
Gearing 𝑟𝑎𝑡𝑖𝑜=Long term debts /Shareholders’ equity
A high gearing ratio shows that a firm has more long-term debt than equity. This is an indication of the company’s exposure to high financial risk.
Lenders are particularly concerned about the gearing ratio. This is because an excessively high gearing ratio will signal a risk of non-repayment of their loans.
In conclusion, it is important to note that, too much debt can be dangerous for a company and its investors.
On the other hand, too few debts can also raise questions. A reluctance or inability to borrow may be a sign that operating margins are tight.
Thanks for reading.
