Debt/equity ratio analysis practice questions.

A company has non-current liabilities of 300000 and total equity of 500000. Calculate its debt/equity ratio.

• 0.375
• 0.60
• 1.67
• 0.30

Answer: 0.60

Debt/equity ratio = long-term debt ÷ equity = 300000 ÷ 500000 = 0.60. The distractor 0.375 mistakenly divides debt by (debt + equity).

A firm's capital employed is 800000, of which 200000 is long-term debt. Calculate the gearing ratio.

• 33.3%
• 25%
• 40%
• 20%

Answer: 25%

Gearing = long-term liabilities ÷ capital employed × 100 = 200000 ÷ 800000 × 100 = 25%. Dividing debt by equity (600000) instead would wrongly give 33.3%.

Which action would most directly reduce a highly geared company's gearing ratio?

• Taking out a new long-term bank loan
• Issuing additional ordinary shares to raise equity
• Increasing the dividend paid to shareholders
• Purchasing a fixed asset using an overdraft

Answer: Issuing additional ordinary shares to raise equity

Issuing new shares raises equity and, if used to repay debt, lowers the proportion of debt in capital employed, reducing gearing. New loans or overdraft-funded purchases raise debt and increase gearing.

Which stakeholder group is most directly concerned by a rising gearing ratio?

• Customers, because prices may rise
• Lenders, because of greater default risk
• Employees, because of reduced training
• Suppliers, because of shorter lead times

Answer: Lenders, because of greater default risk

A higher gearing ratio means more debt relative to equity, increasing the risk that interest and repayments cannot be met, which most directly worries lenders assessing default risk.

A gearing ratio is generally considered high when it exceeds which approximate threshold?

• 10%
• 25%
• 50%
• 90%

Answer: 50%

As a common rule of thumb, gearing above roughly 50% is regarded as high, indicating the business relies heavily on long-term debt rather than equity.

A capital-intensive utility with stable, predictable cash flows carries high gearing. Why might this be acceptable?

• Predictable revenue makes interest payments reliable
• High gearing removes any obligation to pay interest
• Debt finance never has to be repaid
• Shareholders lose all voting rights under high gearing

Answer: Predictable revenue makes interest payments reliable

Stable, predictable cash flows allow such firms to meet fixed interest obligations comfortably, so higher gearing carries less risk than it would for a firm with volatile earnings.