Business
Leverage Ratios
Leverage ratios measure the extent to which a company relies on debt to finance its operations and growth. They provide insight into the company's financial risk and ability to meet its debt obligations. Common leverage ratios include the debt-to-equity ratio, debt ratio, and interest coverage ratio, which are used by investors and creditors to assess a company's financial health and stability.
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11 Key excerpts on "Leverage Ratios"
eBook - PDFFinancial Intelligence for IT Professionals
What You Really Need to Know About the Numbers
- Karen Berman, Joe Knight, John Case(Authors)
- 2008(Publication Date)
- Harvard Business Review Press(Publisher)
Again, note one thing about all these ratios: the numerator is some form of profit, which is always an estimate. The denominators, too, are based on assumptions and estimates. The ratios are useful, particularly when they are tracked over time to establish trend lines. But we shouldn’t be lulled into thinking that they are impervious to artistic effort. 154 RATIOS 21 Leverage Ratios The Balancing Act L everage ratios let you peer into how—and how extensively—a company uses debt. Debt is a loaded word for many people: it conjures up images of credit cards, interest payments, an enterprise in hock to the bank. But consider the analogy with home ownership. As long as a family takes on a mortgage it can afford, debt al-lows them to live in a house that they might otherwise never be able to own. What’s more, homeowners can deduct the interest paid on the debt from their taxable income, making it even cheaper to own that house. So it is with a business: debt allows a company to grow beyond what its invested capital alone would allow and, indeed, to earn profits that expand its equity base. A business can also deduct interest payments on debt from its taxable in-come. The financial analyst’s word for debt is leverage . The implication of this term is that a business can use a modest amount of capital to build up a larger amount of assets through debt to run the business, just the way a person using a lever can move a larger weight than she otherwise could. The term leverage is actually defined in two ways in business—operating leverage and financial leverage. The ideas are related but different. Operat-ing leverage is the ratio between fixed costs and variable costs; increasing your operating leverage means adding to fixed costs with the objective of reducing variable costs. A retailer that occupies a bigger, more efficient store and a manufacturer that builds a bigger, more productive factory are
eBook - PDF- Stephen L. Nelson(Author)
- 2021(Publication Date)
- For Dummies(Publisher)
Leverage Ratios Leverage Ratios measure how much debt a firm carries and how easily a firm pays the interest expenses of carrying that debt. Leverage Ratios are important for an obvious reason: Typically, a firm financed mostly with debt needs to continue to borrow to stay in business. (If this doesn’t make sense, think about what happens if a bank won’t extend a loan or won’t refinance a mortgage to a firm that’s heav -ily dependent on debt!) What’s more, a firm that carries a lot of debt typically also spends a lot of money on interest expense. The heavy interest expense means that it’s especially impor -tant for such a firm to have adequate operating income. Operating income is the income available to pay interest and other profits. A firm with a lot of operating income relative to its interest expense doesn’t have much of a problem paying the interest — and this is true even if operating income declines or decreases. By contrast, a firm with very modest operating income relative to its interest expense quickly gets into trouble if the operating income decreases. Debt ratio The debt ratio simply shows the firm’s debt as a percentage of its capital struc -ture. The term capital structure refers to the total liabilities and owner’s equity amount. In the case of the balance sheet shown in Table 1-1, the capital structure totals $320,000. Not coincidentally, the total liability and owner’s equity amount ($320,000) equals the total assets amount ($320,000). This makes sense if you think about it a bit. A firm funds its assets with its capital. Therefore, the total assets always equal the total capital structure.
eBook - PDF- Timothy Mayes(Author)
- 2020(Publication Date)
- Cengage Learning EMEA(Publisher)
In finance, leverage refers to a multiplication of changes in prof- itability measures. For example, a 10% increase in sales might lead to a 20% increase in net income. 3 The amount of leverage depends on the amount of debt that a firm uses to finance its operations, so a firm that uses a lot of debt is said to be “highly leveraged.” 3. As we will see in Chapter 7, this would mean that the degree of combined leverage is 2. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 3 Financial Statement Analysis Tools 84 Leverage Ratios describe the degree to which the firm uses debt in its capital structure. This is important information for creditors and investors in the firm. Creditors might be concerned that a firm has too much debt and will therefore have difficulty in repaying loans. Investors might be concerned because a large amount of debt can lead to high volatility in the firm’s earnings. However, most firms use some debt because the tax deductibility of interest can increase the stock price. We will examine several ratios that measure the amount of debt that a firm is using. How much is too much depends on the nature of the business.
eBook - PDF- Laurence Booth, Ian Rakita(Authors)
- 2020(Publication Date)
- Wiley(Publisher)
Leverage is synonymous with magnification. It is good when a firm is low risk and earns a healthy ROA, since it magnifies these high ROAs into even higher ROEs. However, when the firm loses money, the use of leverage magnifies ROEs on the downside as well. This can get the firm into serious trouble. We will discuss the leverage decision in more detail when we discuss the firm’s capital structure in chapters 20 and 21. But for now, we will introduce the major ratios to consider 6 The choice of fiscal year end can have a significant impact on reported financial ratios, based on annual financial statements, especially for firms that face a seasonal sales cycle. As a result, several balance sheet items, such as loans outstanding, accounts receivable, inventory, and accounts payable, will vary considerably during the year. The analyst must be aware of these factors when evaluating the ratios and also when comparing to other “similar” firms that choose different fiscal year ends. 4. 3 Leverage Ratios 4-7 when discussing financial leverage. There are basically three types: stock ratios, flow ratios, and other ratios. Stock ratios indicate the amounts of debt outstanding at a particular time. For leverage, there are three basic stock ratios: the leverage ratio (discussed previously), the debt ratio, and the debt‐equity ratio. The debt ratio is defined as total liabilities (TL) divided by total assets (TA), as shown in Equation 4.8. 7 Debt ratio = TL ___ TA [4.8] For CP in 2018, Debt ratio = TL ___ TA = $14,618 ______ $21,254 = 0.6878 The debt ratio is just a rearrangement of the leverage ratio, which for CP was 3.2028. 8 The debt ratio as defined includes all liabilities, including money that a company owes suppliers. But in a broad sense, these liabilities are not debt in the way that bank debt is debt. These lia- bilities arise as a result of normal operations, not from someone deciding to invest in, or lend money to, CP.
eBook - ePubRational Investing with Ratios
Implementing Ratios with Enterprise Value and Behavioral Finance
- Yannick Coulon(Author)
- 2019(Publication Date)
- Palgrave Pivot(Publisher)
© The Author(s) 2020 Y. Coulon Rational Investing with Ratios https://doi.org/10.1007/978-3-030-34265-4_4Begin Abstract4. Debt Ratios
Yannick Coulon1(1) Brest Business School, Brittany, FranceYannick CoulonAbstract
Debt, as much as an opportunity as a threat, must be monitored. First, financial leverage and its effects on income, both positive and negative, must be defined.The core of the chapter focuses on debt ratios by comparing the relative size of debt to equity on the balance sheet, or by comparing the relative size of debt or its repayment to the cash flows generated by the company.Two case studies illustrate the limits of the classic debt to equity approach based on book value. Excessive financial leverage is then addressed via the instability theory of the late professor Hyman P. Minsky. Finally, a sample of large players in three sectors is displayed to show that debt levels are sector related. Key takeaways on debt ratios and their limitations conclude the chapter.Keywords Financial leverage Debt to equity ratios Debt coverage ratiosEnd AbstractFinancial instability hypothesis of professor Hyman P. MinskyCreditworthiness4.1 Introduction on Indebtedness
Debt, as much as an opportunity as a threat, must be monitored. The company financing mix between debt and equity must be optimal (i.e., trade-off between the low after-tax cost of repayable loans versus the high cost of stable and permanent equity).There is an inherent conflict of interest between lenders and equity holders. Additional borrowing enhances shareholder profitability, but it represents a risk for lenders as they become more exposed without benefiting from the additional return. Therefore, there is a limit beyond which lenders will not further finance the expansion of a company.
eBook - PDF- Walter Reid, D R Myddelton(Authors)
- 2017(Publication Date)
- Routledge(Publisher)
FINANCIAL STATUS RATIOS Ratios of financial status measure a company’s ability to meet its liabilities. They can be divided between: Solvency ratios – dealing with long-term liabilities. Liquidity ratios – dealing with short-term liabilities. Please refer again to the 2005 accounts of Precision Locks Limited (opposite, left) and calculate the following financial status ratios. Then turn to the next page, and compare your answers with the ratios shown there. As you calculate the ratios, consider what they mean and how they contribute to your appraisal of the company’s financial status. SOLVENCY RATIOS 2005 2004 Debt ratio Debt = = 20.0% Capital employed Interest cover Profit before interest and tax = = 7.0 times Loan interest LIQUIDITY RATIOS Current ratio Current assets = = 2.5 times Current liabilities Acid test Liquid assets (debtors + cash) = = 1.05 times Current liabilities 43 SOLVENCY RATIOS Debt Debt 100 Debt ratio: = = = 18.2% Capital employed Debt + Equity 550 Debt is 18 per cent of the capital employed, which means (in this simple case) that equity is the other 82 per cent. This relatively low debt ratio (‘gearing’) gives lenders a fairly high level of safety (‘equity cushion’). Another way of measuring the same thing is the ‘debt/equity’ ratio: Debt Debt 100 = = = 22.2% Shareholders’ funds Equity 450 Both these gearing ratios are common, so it is important not to confuse them. Bank overdrafts are legally repayable ‘on demand’, and appear under ‘Creditors due within one year’. But both bank overdrafts and any current portions of long-term debt represent negotiated interest-bearing finance. They may best be regarded as part of a company’s interest-bearing capital employed. They contrast with ‘spontaneous’ sources of funds, normally not bearing interest, such as trade credit or tax payable. The net debt ratio uses ‘debt less cash’, in this case 100 – 40 = 60.
eBook - PDFCorporate Finance
Theory and Practice in Emerging Economies
- Sunil Mahajan(Author)
- 2020(Publication Date)
- Cambridge University Press(Publisher)
Let us discuss some of the ratios pertaining to financial leverage. Debt to Assets Debt to total assets ratio = total debt/total assets. The debt includes both the short-term as well as the long-term. The ratio gives an indication of the proportion of funds contributed by the lenders. Higher the ratio, higher the ROE is likely to be but with a higher risk. Debt to Equity Debt to equity ratio=total debt/shareholders’ equity. This is another way to represent the contribution of debt and shows how much the creditors have provided for every Indian rupee of equity. Let us assume that a company with an asset base of ₹1 billion is financed ₹750 million by equity and ₹250 million with debt. The debt to asset ratio is 25/100 = 0.25 while the debt to equity ratio is 25/75 = 0.33. What this implies is that 25 per cent of funding comes from debt. In other words, debt equals 33 per cent of equity. Both provide the same information but viewed from different angles. Equity multiplier ratio equals total assets divided by equity. In the preceding paragraph, assets are ₹1 billion and equity is ₹750 million, yielding an equity multiplier of 100/75 = 1.33. You would have observed that the equity multiplier equals 1 plus the debt–equity ratio. Coverage Ratios The financial Leverage Ratios concentrate on the balance sheet only; debt, equity and asset figures are all a part of the balance sheet. Whether the debt obligations represented earlier are worrisome and risky or not will depend on the ability of the company to meet its obligations from profitability and cash flows. Two companies with similar debt–equity ratios will differ in their ability to service the debt if their profitability from operations is different. Higher profitability will make the balance sheet ratios of debt and equity look safe, whereas low profitability will make the same ratios look extremely risky. We, therefore, need to take into consideration the income statement also, besides the balance sheet.
No longer available |Learn moreThe Art of Company Valuation and Financial Statement Analysis
A Value Investor's Guide with Real-life Case Studies
- Nicolas Schmidlin(Author)
- 2014(Publication Date)
- Wiley(Publisher)
Chapter 3
Ratios for Financial Stability
Change alone is eternal, perpetual, immortal. Arthur SchopenhauerA long-term investment has to fulfil two fundamental criteria. First, it should yield an appropriate return on the invested capital. Indicators for this were introduced in Chapter 2. Second, a business can operate successfully in the long run only if it has a solid capital structure and sufficient cash flow. The following chapter provides ratios to validate and quantify the financial stability of a company. Although profitability ratios were introduced first, the importance of financial stability can hardly be overestimated. Particularly in the business world, Murphy’s Law is more applicable than ever: anything that can go wrong, will go wrong.3.1 EQUITY RATIO
Equity ratio indicates which proportion of the total assets is funded by shareholders’ equity.Companies with high equity ratios are usually considered to be conservatively financed. The higher the equity ratio, the lower the company’s use of leverage. In contrast to shareholders’ equity, debt has the advantage of being tax-deductible, as interest expenses are usually tax-deductible, lowering the company’s tax burden. Moreover, debt is a cheaper source of funding than equity, because in the case of insolvency, creditors’ claims rank senior to equity and hence will be paid back first. Creditors are therefore exposed to lower risk and will consequently demand a lower compensation in return. Shareholders, meanwhile, will be considered only after creditors have been fully paid out. Since debt is cheaper than equity, a certain proportion of borrowed capital can be found in any business to lower the total cost of capital. In addition to that, when funding its working capital, a minimum amount of debt is sensible. Inventory, for instance, is usually funded by supplier credits or revolving credit lines. However, increasing levels of debt raises the risks for an enterprise, as the interest burden grows and the debt has to be paid back or refinanced at some point in time. Especially in a downturn, the fixed nature of interest payments can become problematic for businesses that operate in cyclical industries or have low profit margins in general. Paracelsus’s theory also applies to the use of debt: the dose makes the poison.
eBook - PDF- Henry E. Riggs(Author)
- 2022(Publication Date)
- Springer(Publisher)
And the reverse: an increase in the dividend rate may result in a higher price for the stock if investors bid up that price until yield returns to its former percentage. INTERPRETING RATIOS Interpreting ratios is an art, not a science. To repeat, the analyst is using ratios to diagnose corporate strengths and weaknesses. Ratios are typically not the end of the analysis but the beginning; they help guide the analyst to those areas and aspects of the business where he or she wants to dig deeper, ask more questions. Despite tempting conventional wisdoms, there are no “right values” for various ratios. In fact, you cannot even say that the higher the ratio—or the lower the ratio—the better. Just because very high debt leverage is very risky does not mean that very low debt leverage is a good thing; is the corporation that eschews debt wise to forego the positive effects of debt leverage? Again, while low liquidity ratios (for example, a low current or quick ratio) may signal danger, a very high current ratio signals inefficient use of current assets—perhaps excess cash EVALUATING WITH RATIOS 89 Exhibit 7.1: Federated Department Stores, Inc. Key Financial Ratios, 2002–2004 END OF JANUARY RATIO 2005 2004 2003 Current ratio 1.7 1.9 Accounts receivable collection period (days) 80 72 Inventory turnover (times per year) 3.0 2.8 Total asset turnover 1.05 1.05 Long-term debt/total capitalization (%) 34 39 Gross margin 40.5% 40.4% 40.0% ROS (return on sales) 4.4% 4.5% 4.1% ROE (return on equity) 11.2% 11.7% ROA (return on assets) 9.4% 9.2% Cash flow before financing/dividends (times) 8.4 14.9 Inf. Cash flow from operations/cash flow for investing 2.1 2.4 1.8 or too much inventory. The corporation’s finance officer may seek rapid A/R collection, but to the marketing manager “payment terms” are only one element of a complex customer-supplier relationship; the optimum collection period trades off financial and marketing considerations.
eBook - PDFCorporate Finance
Economic Foundations and Financial Modeling
- Michelle R. Clayman, Martin S. Fridson, George H. Troughton, Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
- 2022(Publication Date)
- Wiley(Publisher)
CHAPTER 6 MEASURES OF LEVERAGE Pamela Peterson Drake, PhD, CFA James Madison University (USA) Raj Aggarwal, PhD, CFA Kent State University Foundation Board (USA) Cynthia Harrington, CFA teamyou.co (USA) Adam Kobor, PhD, CFA New York University (USA) LEARNING OUTCOMES The candidate should be able to: • define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk • calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage • analyze the effect of financial leverage on a company’s net income and return on equity • calculate the breakeven quantity of sales and determine the company’s net income at various sales levels • calculate and interpret the operating breakeven quantity of sales 1. INTRODUCTION This chapter presents elementary topics in leverage. Leverage is the use of fixed costs in a company’s cost structure. Fixed costs that are operating costs (such as depreciation or rent) create operating leverage. Fixed costs that are financial costs (such as interest expense) create financial leverage. Analysts refer to the use of fixed costs as leverage because fixed costs act as a fulcrum for the company’s earnings. Leverage can magnify earnings both up and down. The profits of 189 highly leveraged companies might soar with small upturns in revenue. But the reverse is also true: Small downturns in revenue may lead to losses. Analysts need to understand a company’s use of leverage for three main reasons. First, the degree of leverage is an important component in assessing a company’s risk and return characteristics. Second, analysts may be able to discern information about a company’s business and future prospects from management’s decisions about the use of operating and financial leverage. Knowing how to interpret these signals also helps the analyst evaluate the quality of management’s decisions.
eBook - PDF- Dana L. Hoag(Author)
- 2009(Publication Date)
- CRC Press(Publisher)
340 15.3.4.1 Term Debt and Capital Lease Coverage Ratio ................... 340 15.3.4.2 Capital Replacement and Term Debt Repayment Margin ................................................................................ 340 15.3.5 Financial Efficiency Ratios ............................................................... 340 15.3.5.1 Asset Turnover Ratio ......................................................... 341 15.3.5.2 Operating Expense Ratios ................................................. 341 15.4 Credit Scoring Models .................................................................................. 342 15.5 Summary ...................................................................................................... 342 References .............................................................................................................. 342 Further Reading ..................................................................................................... 342 324 Applied Risk Management in Agriculture We discussed financial analysis and introduced a condensed set of financial state-ments to help learn the concepts of financial analysis in Chapter 5. Other chapters covered use of risk management tools to reduce or eliminate the five basic types of risk. Each of these tools requires a clear understanding of how the tool helps control a particular risk and how each tool is implemented, but the results of imple-menting a particular risk management strategy will usually have some type of financial implication. We will continue to explore financial analysis concepts and the impact of implementing some of the risk management strategies discussed in this chapter. Financial analysis for an operation measures the cumulative effect of managing, or not managing, various individual types of risk (Boehlje, Dobbins, and Miller, 2000).
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