Most companies in the initial stages of their business to borrow money from banks or other lenders at a certain interest rate. These funds are categorized as debt and the ratios that measure the amount of debt are termed as Leverage Ratios. Since raising funds in the form of debt is much more cost-efficient than fundraising through equity, many companies use it as a preferred option to fund their growth requirements. However, a huge portion of the debt on a company’s balance sheet might have other repercussions related to its ability to service debt, net profit margin and much more.
Leverage ratios measure the relative amount of funds supplied by equity and debt lenders. The focus is on the long-term solvency of the firm. In general, the higher the amount of debt financing relative to equity financing, the more leveraged is the firm is and the accompanying risk.
These financial risk ratios are also referred to as Debt Ratios, as these ratios indicate the company’s ability to meet their long-term debt obligations. Some of the frequently used leverage ratios are debt ratio, equity ratio, debt to equity ratio, interest coverage ratio, the degree of operating leverage, the degree of financial leverage, the degree of combined leverage etc.
Debt ratio highlights the extent to which company assets were financed through debt. Debt ratio indicates the company’s overall debt liability and the amount of assets the company must liquidate in order to pay off all its borrowings. This ratio is also referred to as Debt to Assets Ratio.
The Debt Ratio is calculated as:
Debt Ratio = Total Debt / Total Assets
A debt ratio of 0.5 is presumed to be the accepted norm, while a higher ratio indicates the increasing liabilities of the company, implying higher financial risk.
Similar to the debt ratio, the Equity Ratio measures the amount of assets financed through the shareholder’s equity. Also referred to as net worth to total assets ratio or proprietary ratio, this ratio indicates the shareholder’s funds to total assets, in addition to indicating the long-term solvency position of the company’s business.
The Equity Ratio is calculated as:
Equity Ratio = Total Shareholder’s Equity / Total Assets, where
Total Shareholder’s Equity = Share Capital + Retained Earnings
The equity ratio can also be calculated as:
Equity Ratio = 1- Debt Ratio
It is important to have an optimal equity ratio due to various reasons. Companies having a higher equity ratio have to pay less interest with access to better capital, thereby having more free cash on hand for organic and inorganic growth and for dividend payouts. At the same time, a company with a lower equity ratio might not be able to secure capital at lower interest rates, and would be more prone to losses for a large portion of its profits would be spent in paying the interest costs.
In the DuPont method, Equity Multiplier is the third parameter used for the computation of return on equity. A measure of financial leverage, the equity multiplier is arrived at by dividing the company's total value of asset by total net equity.
Equity multiplier is calculated as:
Equity Multiplier = Total Assets / Shareholder's Equity = 1 / Equity Ratio
A higher equity multiplier indicates a significant portion of asset financing being ascribed to debt.
The most widely financial ratio of all the leverage ratios is the Debt to Equity ratio and is defined as the ratio of the total debt to the total equity of the company. This ratio provides the proportion of the assets financed by the various entities like suppliers, creditors, banks etc. vis-a-vis the proportion of assets financed by the equity shareholders of the company.
The Debt to Equity Ratio is calculated as:
D/E = Total Debt / Total Shareholder’s Equity
Higher debt to equity ratio is indicative of higher borrowings from lenders and less of equity shareholder’s funds. A higher ratio restricts a company from generating sufficient cash to meet its debt obligations, while a lower ratio might imply the company’s inability in using its financial leverage for improving the business earnings.
Manufacturing and other capital-intensive industries tend to have higher debt-to-equity ratios than service industries due to the requirement of a large quantity of fixed assets to run the operations.
A company raises its capital either through debt & equity and depending upon the phase of growth, operations and investor interest, either debt or equity becomes a major portion of the capital. The Long Term Debt to Capitalization Ratio corresponds to the percentage of a company's long-term debt as compared to its total available capital.
Long term Debt to Capitalization ratio is calculated as:
Long term Debt to Capitalization = Long Term Debt / Total Capital, where
Total Capital = Long term debt capital + Equity capital from all shareholders
Depending upon the company’s performance (high profitability), a higher long term debt capital would be the preferred option as the company would have to pay interest at fixed rates and can retain a large portion of earnings for its growth. In case the company is witnessing volatility in its earnings, then higher equity capital would prove to be a safer option as the company doesn’t have to worry about interest burden or repaying the higher cost equity capital to shareholders.
Also referred to as Times Interest Earned Ratio, the Interest Coverage Ratio computes the number of times a company can pay its interest costs from the earnings before interest and taxes in the same period. This ratio is a margin of safety measure available for a company in paying interest during a given period.
Interest Coverage Ratio is calculated as:
ICR = Earnings before Interest and Taxes (EBIT) / Interest Costs
A stable interest coverage ratio > 1.5 is the accepted norm among most analysts. A value below 1.5 indicates that the company would incur difficulties in continuous payment of its interest costs and that the debt burden will affect the business operations of the company. Hence, it is imperative that any company should borrow funds judiciously and ensure that the interest costs are not rising too high, lest they affect the profitability of the business on the whole.
Degree of Operating Leverage is a measure of the magnitude to which the operating income changes in relation to a change in sales. It is important to understand the effect of operating leverage on a company's earnings potential as well as its earnings dependence on the sales activity. The degree of operating leverage is calculated by dividing the percentage change of a company's earnings before interest and taxes (EBIT) by the percentage change of its sales during the same period.
Degree of Operating Leverage is calculated as:
DOL = Change in EBIT (%) / Change in Sales (%)
The DOL helps in determining the effect of change in sales volume on the profits of the company. A higher operating leverage indicates that even a minor change in sales (%) can increase the net operating income. Operating Leverage measures the operating risk or business risk of the company.
Similar to the DOL, the Degree of Financial Leverage indicates the effect of changes in earnings per share due to the changes in the company's earnings before interest and taxes. The degree of financial leverage is calculated by dividing the percentage change in a company's EPS by its percentage change in EBIT.
Degree of Financial Leverage is calculated as:
DFL = Change in EPS (%) / Change in EBIT (%)
A higher degree of financial leverage implies a higher degree of financial risk, more so if the earnings from operations are volatile with constant interest expense and this can result in an unpredictable EPS for the company. Financial Leverage measures the financial risk of the company.
A leverage ratio that encapsulates the combined effect of the degree of operating leverage and the degree of financial leverage, on the earnings per share for a change in sales is termed as the Degree of Combined Leverage or DCL. This ratio helps determine the most optimal level of financial and operating leverage to use in any company.
Degree of Combined Leverage is calculated as:
DCL = Change in EPS (%) / Change in Sales (%) = DOL * DFL
A company with a relatively high level of combined leverage is seen as riskier compared to a company with less combined leverage, as the high leverage implies more fixed costs to the company and vice versa.
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