Leverage Ratios

Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt.

Generally, companies have two options when they wish to raise money. They can issue shares of stock, which are also known as equities. Alternatively, they can issue bonds, which are also known as debt instruments. Leverage ratios tell investors how much debt a company has outstanding relative to the equity in their capital structure.

Debt Ratio

Debt ratio measures the liabilities of the company relative to total assets. The balance sheet formula tells us Assets = Liabilities + Owner’s Equity. By dividing liabilities by assets, this ratio provides insights into the proportion of debt used to finance the assets of the company.

The debt ratio is defined as total debt divided by total assets:

debt-ratio-onestopbrokers

As is the case with many financial ratios, benchmark comparisons should be made against companies in similar industries. That being understood, the higher the ratio of liabilities to assets, the greater the risk creditors could force the company into bankruptcy if it falls behind on interest payments. Generally, it’s desirable to have a debt ratio that is less than 0.5. When a company’s ratio rises above 0.5, it is said to be highly leveraged.

Debt-to-Equity Ratio

Debt-to-equity ratio compares liabilities to owner’s equity. In doing so, this ratio tells us how much debt is used to finance the company’s assets relative to equity. As was the case with the debt ratio, a lower value offers more protection from creditors if the company falls on difficult financial times.

The debt-to-equity ratio is total debt divided by total equity:

debt-to-equity-ratio-onestopbrokers

It’s very common for businesses to borrow money to fuel their growth. This is especially true for companies in capital intensive industries such as electric utilities and automobile manufacturers. As long as these capital investments provide additional profits to the business, making interest payments to creditors is not problematic. However, if the company’s business suddenly contracts, they may not have enough profits to pay creditors. Debt to equity ratios can vary greatly by industry.

Times interest earned

The times interest earned ratio indicates how well the firm’s earnings can cover the interest payments on its debt. This ratio is also known as the interest coverage and is calculated as follows:

interest-coverage-onestopbrokers

where EBIT = Earnings Before Interest and Taxes

 

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