The Concept Of Leverage Ratios
Leverage ratios are concerned with the long term solvency of a company. They are also known as debt ratios and used to find out if the company is in a position to meet its long term obligations. The key components which are used to assess the solvency position within a company encompass debt, interest expenses, equity and assets. IT requires a good understanding of the capital structure of the company.
A company's capital structure typically comprises equity and debt. Debt is associated with interest payment and repayment of the principal amount. Long term debt also includes lease payments. These liabilities have to be due over the longer term which means over a year's time frame. It is an indicator of the risk level of the capital structure of the company. Financial leverage is thus related to the mix of debt and equity within the capital structure of a business. Debt on the balance sheet means that there are fixed financial charges which have to be paid irrespective of the company's earnings.
However the fixed financial charges can be used by the firm to enhance its earnings per share if there is a positive change in a company's operating income.
Further, the degree of financial leverage is important to be understood as in case of extreme scenarios like liquidation or bankruptcy, the company's debts will have to be paid of first from the asset sale. Long term debtors will have the first claim here. Only after that is repaid in full will anything is left for the shareholders, if at all. Equity shareholders of firms with very high debt entail this risk.
Calculations of these ratios are often a complex process which requires expert help. Let us look at the finer nuances below:
Debt to Equity Ratio
The debt to equity ratio indicates to what extent is the company financed by debt as compared to equity. It reflects the percentage of company's funds which emanate from creditors as well as investors. The numerator will comprise short-term debts like short-term bank loan, current liabilities, and overdraft facilities and debentures and bank loan which are long term in nature.
Debt to Equity = (Short-Term Debt + Long-Term Debt)/Total Equity
Higher the debt, higher will be the ratio of the company. Lenders will look into the company's position to service this debt before lending further. Under and ideal scenario, companies with lower debt are considered less risky. It is a balance sheet ratio as the numbers are all derived from the balance sheet and hence indicate the company's position on the date of the balance sheet.
This ratio calculates the extent to which assets of the business are funded by the shareholder's capital or owner's funds. It indicates the amount left with investors after all the liabilities are met. The assets are taken from the balance sheet of the company. A higher ratio is considered better, other things being equal, as it means that the company's operations are sustainable and entail lower risk.
Interest Coverage Ratio
A debt on the company's balance means that it has to service it or in other words, pay interest on a regular basis and also take care of the final repayment of the principal amount. The interest coverage ratio provides an insight into the company's ability to meet these financial obligations. Operating income is considered as the numerator as it indicates the amount generated from the core operations of the business.
A higher ratio is better as it means the company has enough liquidity to meet is long term obligations with the required amounts and when it is due.
Interest Coverage = Operating Income/Interest Expense
It is indicative of the company's ability to pay off its liabilities with its assets. It indicates as to how many assets the company will need to sell to meet its debt obligations. It is expressed in percentage terms.
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