The debt to equity ratio of a company is simply its level of debt (any type of borrowed money – from bank loans to bonds issued by the company) divided by equity (the shareholders’ money in the business). Expressed as a percentage, this gives the companies ‘gearing’. A company with a high level of debt will have a high debt-to-equity ratio, and hence be ‘highly geared’.
A high level of gearing helps companies to produce better returns for shareholders when times are good, but in bad times, the highly geared are saddled with having to pay interest on their debt. Those which have chosen a high level of equity finance instead of debt, on the other hand, are not obliged to pay out – dividends are discretionary – and can often weather bad times better.
The appropriate mix of debt and equity depends on the type of business – those with stable long-term incomes (tobacco companies, for example) can better cope with being highly geared.
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