The financial leverage ratios measure the debt position of a company. They indicate how much of the company assets belong to the stockholders rather than creditors. The financial leverage ratios are essential to know because firms rely on a mixture of equity and debt to fund their operations. They are key indicator to measure business solvency – the ability of a firm to meet its long term expenditure and to achieve long term business growth. The financial leverage ratios mainly focus on long term ability of a company to pay off its liabilities.
Financial Leverage Ratios to Measure Business Solvency
When stockholders have large amount of investments in the firm’s assets, the firm is considered less leveraged. On the other hand, when creditors have large of debts in the firm’s assets, the firms is said to be highly leveraged. If this situation continues for a long period, it may lead to bankruptcy. Therefore, these analyses are vital for investors to know the capital structure of a firm. In order to measure the capital structure of a firm, the following leverage ratios are considered:
1. Debt ratio
2. Equity ratio
1. Debt ratio
2. Equity ratio
Debt ratio is the ratio of total debt to total assets. In other words, the debt ratio indicates how many assets the firm must sell in order to pay off its total liabilities. It is usually used by creditors (lenders) to determine the amount of debts in a company and the ability to repay its debts. The debt ratio is also used by investors to make sure the company is solvent, is able to fulfill current and future obligations and can make a return on their investments. The debt ratio is calculated by dividing total liabilities by total assets. For example, if a company has total assets of $ 100 million and total liabilities $ 50 million. The debt ratio would be:
Debt ratio = Total liabilities / Total assets
Debt ratio = 50 / 100
Debt ratio = 0.5
The above example tells that the firm has low debt ratio indicating that most of its assets are fully owned. A debt ratio greater than 1.0 indicates that a firm has more debt than assets. While the debt ratio less than 1.0 indicates that a company has more assets than debts as shown in the above example. If the debt ratio is equal to 1.0, it means total liabilities are equal to total assets. In this case, the company would have to sale out total assets in order to pay off its total liabilities. This is highly leveraged, once the total assets are sold, the business no longer can operate. So, it is favorable to have debt ratio less than 1.0.
The equity ratio indicates how much of a company’s total assets are funded by issuing shares rather than borrowing money. In other words, it shows how much of a company’s assets are financed by investors. The equity ratio is calculated by dividing total shareholder equity by total assets. For example, if a company has total shareholder equity $ 120 million and total assets $ 200 million. The equity ratio would be:
Equity ratio = Total shareholder equity / Total assets
Equity ratio = 120 / 200
Equity ratio = 0.6
High equity ratio is considered favorable for a company because it is less risky. The investors look for companies having high equity ratio. Such companies know how to financed assets without incurring substantial debts. The company with high equity ratio is known as ‘conservative company’. The firm with equity ratio more than 0.5 is considered conservative company. While, the firm with equity ratio less than 0.5 is considered leveraged firm. Conservative firms are considered less risky compared to leveraged firms. Leveraged firms pay more interest on debts while conservative firms pay more dividends to shareholders.