Equity is a part of firm gearing. Firms utilize the private or public market to acquire capital for their business, and equity is one of the two major sources of capital. By issuing (selling) equity to the markets the firm can raise money for commercial investments. Each firm has a market value, referred to as the capitalization. The market value is divided by the amount of shares released. The more equity a company releases, the lower stock already owned by shareholders is valued.
The other half of potential funding is loans. Loans require repayment with interest. This can become expensive, depending on the loan interest rate. Additionally, you can only borrow a limited amount of money. So why use loans to raise capital? By balancing loans and equity firms can comfortably pay their loans without excessively sinking the value of equity for sale on the market.
Loans allow firms to invest money without providing it themselves. A firm can use loans to invest in expanding operations. By using loans to fund investments in assets or operations, they can purchase operational increases they can’t currently buy on their own. They still have to pay back the debt. They also must pay back the interest, which is the cost of debt. The return on the investment purchased by debts must exceed the cost of the loans.
Measuring Gearing with Debt to Equity
A good way to measure gearing is using the debt to equity ratio. The debt to equity ratio measures the proportion that assets are funded by debt or by an equity investment, or shareholder’s funds. This measure can indicate future problems with a company’s stability, and solvency.
Debt allows firms to boost the asset base without diluting shareholder control or revenues. The return on assets increase generates profit, the debt generates interest costs. If the return on assets exceeds interest profit from debt financing will exceed the interest cost. If a business is doing well, debt can increase profits for shareholders. During upswings in business, there is a high chance of return on assets exceeding interest. During business downturns, there is a low chance of return on assets exceeding interest. This means that interest costs exceed profits from using debt, and earnings leave the business as interest payments. Debt boosts earnings during upswings and lowers earnings during downswings.
If the debt to equity ratio is high, borrowing has been the preferred method of gearing. The firm will generate greater profit per shareholder during the firm’s business cycle upswings. The interest payments eat a higher percentage of low profits if the trend goes sour. If the debt to equity ratio is low, the firm will not be using debt to boost profits during upswings, but will easily meet interest payments during downturns. The key to debt as a boost to return on assets is in moderation. A firm’s debt level should be in between the two measures, enough debt to comfortably boost profits, but not enough to sink the firm during market downswings.
Debt to equity should only be compared to other firms in the context of industry or competitors. Some industries require high capital investments into assets. These firms require heavy outlays into plant, property, and equipment. Manufacturing and Airlines are examples. These firms will typically have higher debt to equity levels. Other firms, like internet or service companies, do not require heavy capital investments into plant, property, and equipment. These firms will typically have low debt to equity levels. The comparison of debt to equity should only be made amongst firms in the same industry, but typically it is better to accept a moderate or low debt to equity than a higher level.
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