The advantages and disadvantages of the gearing ratio

A higher debt-to-equity ratio means that a company is more at risk of financial problems or insolvency. A company can control its leverage ratio by using it to predict future cash flows and monitor the debt-to-equity ratio.

The disadvantages of the gearing ratio

The gearing ratio is not a good way to show the structure of the company. This is because the gearing ratio does not always reflect an ideal financial situation, but a risky one. These figures can provide information about the financial situation of a company, but they should be compared with historical data and with ratios of competitors.

Influence

Debt ratios may be included in bond covenants, loan agreements or covenants. The debtor agrees to pay its creditors a fixed amount for the leverage ratio. Check https://exnesslatam.com/trading-de-criptomonedas/, in order to know more about how leverage influence trading. A covenant is breached if the upper limit is exceeded. This usually leads to a grace period or an amendment that allows the borrower to meet the covenant. However, if the borrower does not comply with the covenant, the creditor can demand a higher credit limit or an extraordinary right to terminate the loan.

State and local governments

States are debtors and have a completely different economic structure than companies. Structurally, debt can be calculated in the same way as for companies. This is called total debt. External debt refers to debts not associated with the state to foreign creditors. However, this debt still needs to be compared to export earnings or gross domestic product (GDP) to calculate the ratio. This is because export earnings are the primary source of revenue for debt service. GDP is a measure of the country's economic performance over a year. It indicates how much government debt remains in relation to this economic output.

S is the total national debt, and B is the gross domestic product. This is the debt-to-GDP ratio. Art. 126 TFEU. In order to pay off the entire national debt, three fifths would have to be paid by the state to its creditors. Although foreign exchange reserves and new debt are available as secondary sources for debt service, these funds are not intended for this purpose. Therefore, external debt amounting to 150% of export earnings can be considered a sustainable burden.

The increasing debt of German municipalities has been the subject of much discussion for years. Absolute figures play a subordinate role here as well. More important is how debt sustainability can be maintained (see debt service coverage ratio). For this purpose, municipal debt is set in relation to total revenues or only to own revenues. Debt sustainability is given if total revenues exceed total debt.

Example for the calculation of the debt ratio

Let us assume that a company has debts of EUR 2 billion and equity of EUR 1 billion. The debt-equity ratio in this case is either 2 or 200%. This means that the company has 2 EUR of debt for 1 EUR of equity. This is a high debt-equity ratio. For more information on the meaning of a high debt-equity ratio, see the explanations on the debt-equity ratio.The analysis of the indebtedness of a company can also be carried out with the help of the dynamic gearing ratio.