Long Term Solvency: Debt and Gearing Ratios
Debt ratios are concerned with how much the company owes in relation to its size, whether it is getting into heavier debt or improving its situation, and whether its debt burden seems heavy or light.
- When a company is heavily in debt banks and other potential lenders may be unwilling to advance further funds.
- When a company is earning only a modest profit before interest and tax, and has a heavy debt burden, there will be very little profit left over for shareholders after the interest changes have been paid. And so if interest rates were to go up (on bank overdrafts and so on) or the company was to borrow even more, it might soon be incurring interest changes in excess of PBIT. This might eventually lead to the liquidation of the company.
There are two big reasons why companies should keep their debt burden under control. There are four ratios that are particularly worth looking at, the debt ratio, gearing ratio, interest cover and cash flow ratio.
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