LEVERAGE, DEBT RATIOS

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Financial Statement Analysis-FIN621

Lesson-36

LEVERAGE/DEBT RATIOS

(b)

Analysis by long-term creditors: Interest of long-term creditors is to see the long-term

solvency of the business and rate of return on their loans. Solvency is the ability to meet

outside liabilities from total assets. Indicators of solvency are the Long-term Solvency,

which are as follows:-

Debt To-Total-Assets: The debt-to-total assets ratio is derived by dividing a firm's

total debt by its total assets: It indicates percentage of total assets financed by debt

= Total outside liabilities /Debt

= 75 = 37.5%

Total assets (total liabilities +shareholders funds)

200

From creditors' point of view, the lower the debt ratio, the better it is because it means

that shareholders have contributed the bulk of funds and margin of protection to creditors is high.

In addition to the previous ratio, we may wish to compute the following ratio, which deals with only

the long-term capitalization of the firm:

*Long Term debt/ Total Capitalization (Share capital + Fixed Liabilities)

Where total capitalization represents all long-term debt and shareholder's equity. This tells us the

relative importance of long term debt to the capital structure (long-term financing) of the firm.

Leverage: It means operating a business with borrowed money. It should be used to

earn a return (on assets or equity) greater than cost of borrowing i.e. interest. Alternate term for this is

"Gearing".

ii)

Equity ratio: Total stockholders equity (including preferred stock) = 125 = 62.5%

Total assets (total liabilities + shareholders funds)

200

This is opposite of Debt ratio. Low equity ratio indicates extensive use of leverage i.e.

borrowings.

iii) Debt-To- Equity: Ratio of borrowed capital to Shareholders' funds is called Debt Equity Ratio.

The debt-to-equity ratio is computed by simply dividing the total debt of the firm (including current

liabilities) by its shareholders' equity:

= 75 = 0.6 i.e. Debt is 0.6 of Equity =Debt Ratio = 37.5: 62.5 (Debt equity Ratio)

125

Equity Ratio

Creditors would generally like this ratio to be low. The lower the ratio, the higher the level of firm's

that is being provided by shareholders and the larger the creditor cushion (margin of protection) in

the event of shrinking asset values or outright losses.

Depending on the purpose for which the ratio is used, preferred stock is sometimes included as debt

rather than as equity when debt ratios are calculated. Preferred stock represents a prior claim from

the stand point of the investors in common stock: consequently, investors might include preferred

stock as debt when analyzing a firm. The ratio of debt to equity will vary according to the nature of

the business and the variability of cash flows. A comparison of the debt to equity ratio for a given

company with those of similar firms gives us a general indication of the credit worthiness and

financial risk of the firm.

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Financial Statement Analysis-FIN621

Coverage Ratio

Coverage ratios are designed to relate the financial charges of a firm to its ability to service, or

cover, them. One of the most traditional coverage ratios is the interest coverage ratio, or times

interest earned

iv) Interest coverage ratio = operating income available for interest payment = 25 = 5

annual interest expenses.

(Normal ratio 3:5)

This ratio serves as one measure of the firm's ability to meet its interest payments and thus avoid

bankruptcy. In general, the higher the ratio, the greater the likelihood that the company could cover its

interest payments without difficulty. It also sheds some light on the firm's capacity to take on new debt.

Changes in Solvency Ratios indicate changes in enterprise activities; its expansion or

contraction.

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