Stability ratios provide insights to a business’s financial stability and security.
The gearing ratio expresses the relationship between a company’s debt and its total capital employed. Gearing is calculated as net debt (total debt less excess cash) expressed as a percentage of total capital (equity and net debt combined).
Debt is an important component of funding for many small businesses, enabling growth and long-term investment. However, too much debt can be disastrous if a business is unable to meet its repayment commitments. Therefore gearing is an important measure of how reliant a business is on debt; the higher the gearing level, the higher the perceived financial risk.
Debt to equity ratio
Similar to the gearing ratio, the debt to equity ratio compares the value of net debt to the value of shareholders’ equity.
Debt service cover
Debt service cover provides insights to a business’s ability to repay its debts out of earnings. It is calculated by dividing the earnings (before interest and tax) of a period by the debt repayment obligations (capital and interest) of the same period.
An improvement in the ratio over time may suggest an increased capacity to service and repay the debt; a fall in the ratio warrants further investigation as it could point to a reduction in capacity to meet future debt commitments.
Book versus real values
A word of warning: ratio calculations (including stability ratios) based on values shown in the accounts may misrepresent the position where the true value of a company’s assets and liabilities differs from the “book value”.
Perhaps the most common example concerns tangible fixed assets, which tend to be shown at “depreciated historic cost” unless a policy of revaluation has been adopted. For this reason, the open market value of land & buildings shown in the accounts of a small company will often be significantly different to the value shown in the balance sheet, particularly if the properties in question were acquired a long time ago. This has a knock-on effect to other numbers in the accounts including shareholders’ equity.
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