A company or a community has 5 million debts, sounds a lot. But this exemplary sum does not provide any information about the debt of a company, a municipality or a state. Rather one needs the degree of indebtedness, also indebtedness ratio. However, the debt-equity ratio is not only made up of the debt in its entirety, but other economic figures also play a role here. This includes, for example, the income, or more precisely the profit that is generated. The latter is decisive as it remains as equity after deduction of all expenses and can also be used to pay debts. In financial terms, the debt-equity ratio is the ratio of debt to equity.
Differences in the degree of indebtedness
In addition to the normal level of debt, there is another variant. This includes, for example, the dynamic gearing ratio. In the calculation of indebtedness, the cash flow is used instead of equity. Of course, the question arises as to why it is necessary to determine the level of indebtedness of a company, a municipality or a state? This has essentially to do with the financing. Often you need loans from banks and financing companies to finance your projects. Of course, they want to keep the risk of credit default as low as possible. Annual financial statements or the like, however, often provide little information about the actual state of the finances. Especially because often only snapshots are limited to one year and the general overview is missing. With the information on the existing level of debt, banks can estimate whether another loan and the resulting repayment and interest figures are affordable. the higher the level of debt, the less free the bank will be. Capital is at the disposal of a company or a municipality. Accordingly, the liquidity also decreases with the increase, when the consequence can be that further loans are no longer available or are no longer available in the desired amount. And even if banks still grant loans, they may have high interest rates or require collateral. This can ultimately turn into a vicious circle, as it can further increase the level of debt, which in turn has a negative impact on debt sustainability and liquidity.
Can have severe consequences as an upper limit
However, the gearing ratio cannot be neglected in other respects either. If, for example, financing contracts already exist, there may be an upper limit for debt. This is formulated in a debt-equity ratio. If this degree is exceeded, the consequences can be severe. If it is the subject of a contract, it is a breach of contract. In most cases, the financing contracts are terminated after a short period of time in order to reduce the debt. This is where the extraordinary right of termination comes into effect, which means that all credit claims are due for payment directly. As can be seen from this, the debt-equity ratio can not only provide a degree of information, but can also be an integral part of a contract. Companies in particular are therefore generally concerned with keeping their debt ratio as low as possible.