Leverage Ratio (Debt Ratio)
Leverage ratio in finance is a general term for any technique intended to multiply profits and losses. Common leverage techniques are debt, the purchase of long-term assets and derivatives (such as warrants). Leverage Ratios are:
Debt Ratio = Total Liabilities ÷ Total Assets
Measures the portion of company assets that is financed by debt (obligations to third parties). Debt ratio can also be computed using the formula: 1 minus Equity Ratio.
Equity Ratio = Total Equity ÷ Total Assets
Determines the portion of total assets provided by equity (i.e. owners’ contributions and the company’s accumulated profits). Equity ratio can also be computed using the formula: 1 minus Debt Ratio.
The reciprocal of equity ratio is known as equity multiplier, which is equal to total assets divided by total equity.
Debt-Equity Ratio = Total Liabilities ÷ Total Shareholders’ Equity
The debt-to-equity ratio is a financial metric that measures a company’s financial leverage, which is the degree to which a company uses debt to finance its operations. It is calculated by dividing a company’s total liabilities by its total shareholders’ equity.
Evaluates the capital structure of a company. A D/E ratio of more than 1 implies that the company is a leveraged firm; less than 1 implies that it is a conservative one.
A higher debt-to-equity ratio indicates that a company is relying more on debt financing than on equity financing. This can be risky, as a company with a high debt load may have difficulty meeting its debt obligations if its earnings decline or if interest rates rise. However, a company with a low debt-to-equity ratio may be missing out on opportunities to grow its business by taking on more debt.
Calculation:
Assume a company has total liabilities of $100 million and total shareholders’ equity of $50 million. The debt-to-equity ratio would be:
Debt-to-Equity Ratio = 100 million / 50 million = 2
Long-term Debt to equity = Long term debt ÷ Average Shareholders Equity
It is a method used to determine the leverage that a business has taken on. To derive the ratio, divide the long-term debt of an entity by the aggregate amount of its common stock and preferred stock.
When the ratio is comparatively high, it implies that a business is at greater risk of bankruptcy, since it may not be able to pay for the interest expense on the debt if its cash flows decline. This is more of a problem in periods when interest rates are increasing, or when the cash flows of a business are subject to a large amount of variation, or when an entity has relatively minimal cash reserves available to pay down its debt obligations. It is sometimes used to compare the leverage level of a business with those of its competitors, to see if the leverage level is reasonable. The standard debt-to-equity ratio can be a more reliable indicator of the financial viability of a business, since it includes all short-term debt as well. This is especially the case when an organization has a large amount of debt coming due within the next year, which would not appear in the long-term debt to equity ratio.
Debt service coverage ratio = Net Operating Income ÷ Total Debt Service
This ratio measures the net operating income available to pay the short-term debt. The DSCR is a useful benchmark to measure an individual or firm’s ability to meet their debt payments with cash. A higher ratio implies that the entity is more creditworthy because they have sufficient funds to service their debt obligations – to make the required payments on a timely basis.
Times Interest Earned Ratio (Interest Coverage Ratio)
The times interest earned ratio, also known as the interest coverage ratio, is a financial metric that measures a company’s ability to meet its interest expense obligations. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense.
Formula:
Times Interest Earned Ratio = EBIT / Interest Expense
Explanation:
A higher times interest earned ratio indicates that a company is generating enough income to cover its interest expense. This suggests that the company is less likely to default on its debt obligations. A lower times interest earned ratio suggests that the company may be having difficulty meeting its interest expense obligations.
Calculation:
Assume a company has EBIT of $20 million and interest expense of $5 million. The times interest earned ratio would be:
Times Interest Earned Ratio = 20 million / 5 million = 4
In general, a debt-to-equity ratio of 2 or lower is considered to be conservative, while a ratio of 5 or higher is considered to be aggressive. A times interest earned ratio of 3 or higher is considered to be healthy, while a ratio of less than 1 is considered to be risky.
Examples
1. Compute for the company’s debt ratio for the following figures have been obtained from the balance sheet of ABC Company.
| Current assets | 3,500,000 |
| Non-current assets | 12,100,000 |
| Total assets | 15,600,000 |
| Total liabilities | 11,480,000 |
| Stockholders’ equity | 4,120,000 |
| Total liabilities and equity | 15,600,000 |
The above figures will provide us with a debt ratio of 73.59%, computed as follows:
| Debt ratio | = | Debt / Assets |
| = | 11,480 / 15,600 | |
| = | 73.59% |
Alternatively, if we know the equity ratio we can easily compute for the debt ratio by subtracting it from 1 or 100%. Equity ratio is equal to 26.41% (equity of 4,120 divided by assets of 15,600). Using the equity ratio, we can compute for the company’s debt ratio.
| Debt ratio | = | 1 – Equity ratio |
| = | 1 – .2641 | |
| = | .7359 or 73.59% |
2. Calculate debt ratio for Hello Inc. based on the information given below:
| Current assets | 500,000 |
| Non-current assets | 845,000 |
| Non-current liabilities | 340,000 |
| Current liabilities | 270,000 |
| Accounts payable | 20,000 |
Solution
Total assets = $500,000 + $845,000 = $1,345,000
Total debt = $340,000 + ($270,000 – $20,000) = $590,000
Note that we excluded accounts payable from total liabilities because it is not debt.
| Debt Ratio = | $590,000 | = 0.44 |
| $1,345,000 |
3. Calculate the debt to equity ratio for the HiHello Inc. and assume they are having following figures:
| Debentures | 10000 |
| Long-term Liabilities | 15000 |
| Short-term Liabilities | 5000 |
| Shareholder’ Equity | 10000 |
| Reserves and surplus (R&S) | 25000 |
| Retained Profits | included in R&S |
| Fictitious Assets | 500 |
| Accumulated Losses | 0 |
Their debt equity ratio, we will calculate as follows:
Debt Equity Ratio = (10000+15000+5000) / (10000+25000-500) = 30000/ 34500 = 0.87.
4. Aldo’s Shoe Store is looking to remodel its storefront, but it doesn’t have enough cash to pay for the remodel it self. Thus, Aldo is talking with several banks in order to get a loan. Aldo is a little worried that he won’t get a loan because he already has several loans.
According to his financial statements and documents, Aldo’s had the following:
| Net Operating Profits | $150,000 |
| Interest Expense | $55,000 |
| Principle Payments | $35,000 |
| Sinking Fund Obligations | $25,000 |
Here is Aldo’s debt service coverage calculation:
1.3 = 150 000 / (55 000 + 35 000 + 25 000)
As you can see, Aldo has a ratio of 1.3. This means that Aldo makes enough in operating profits to pay his current debt service costs and be left with 30% of his profits.
5. Calculate debt service coverage ratio and let’s say you are analyzing ABC, Inc. financial statements for financial year 2020. Following is an extract from the financial statements. All amounts are in million USD.
| Net income | 45 |
| Taxes | 30 |
| Capital (finance) lease-interest expense | 7 |
| Capital (finance) lease-principal repayments | 13 |
| Capital (finance) lease total payment | 20 |
| Interest expense on loans | 13 |
| Debt payments (including both interest and principal) | 30 |
Calculate debt service coverage ratio.
Solution
Debt service coverage ratio includes operating income in the numerator and debt payments in the denominator.
Let us first calculate the components.
Operating income
= net income + taxes + capital (finance) lease + interest expense on loan
= $45 million + $30 million + $7 million + $13 million
= $95 million
Debt payments
= loan re-payments + total lease payments
= $30 million + $20 million
= $50 million
Debt service coverage ratio = $95 million/$50 million = 1.9
A debt service coverage ratio of 1.9 is pretty good. In fact, a ratio greater than 1 indicates that the company generated profit before interest and taxes that’s more than its obligations under its debts.
6. ABC Inc. has net income of $100,000, income taxes of $20,000, and interest expense of $40,000. Based on this information, its times interest earned ratio is 4:1. Calculate the times interest earned ratio.
Solutions:
A business has net income of $100,000, income taxes of $20,000, and interest expense of $40,000. Based on this information, its times interest earned ratio is 4:1, which is calculated as:
($100,000 Net income + $20,000 Income taxes + $40,000 Interest expense) ÷ $40,000 Interest expense
Sources: PinterPandai, Corporate Finance Institute
