Before we discuss the leverage ratios, let us quickly understand what leverage is. Leverage is simply usage of debt to finance a company’s activities. A company’s activities can be financed either by own money of the shareholders i.e. equity or borrowed money i.e. debt.
As debt holders have contractual claims on predefined return and have the ability to take punitive measures such as confiscation of assets or force liquidation of the company, the risk associated with debt is lower than the equity. Therefore, the cost of debt is generally lower than equity. Apart from that, interest payments reduce the taxable income for the company lowering the tax burden. Also, from Dupont Analysis, we can see the increasing debt increases the ROE without any improvement in the net margin or asset turnover. Because of these benefits, managers may prefer debt over issuing equity.
But, the use of debt increases the risk associated with the equity of the company. First of all, increasing debt means increasing interest payment – the payments have to be made irrespective of a company's financial performance. This means if the company’s revenue is volatile, the increased interest payment will increase the volatility of the net income i.e. the money available for the equity holders. Defaulting on the interest payment may lead to insolvency. In case of liquidation of a company, the debt holders get preference in the money received from liquidation to the extent that nothing might be left for the shareholders.
DEBT TO ASSET (D/A) RATIO
D/A = Total Liabilities / Total Assets
This ratio simply tells us the debt in the companies balance sheet.
DEBT TO EQUITY (D/E) RATIO
D/E = Total Liabilities / Total Shareholder’s Equity
This ratio tells us how much debt the company has compared to equity. A higher ratio means aggressive financing of the company using debt but also means that if the company fails to convert the investments into income, the results will be much more serious for the shareholders.
It is important that we compare the D/E ratio with our peers and do not consider it standalone.
EQUITY MULTIPLIER OR ASSET TO EQUITY RATIO
Equity Multiplier = Total Assets / Total Shareholder’s Equity
= (Total Shareholder’s Equity + Total Liabilities) / Total Shareholder’s Equity
= 1 + (Total Liabilities / Total Shareholder’s Equity)
= 1+ (D/E Ratio)
We can see from Dupoint Analysis that the equity multiplier has a multiplying effect on the return on equity.
Till this point, we have seen the ratios which can be calculated using the balance sheet. Now, we will see ratios which require both the balance sheet and profit & loss statement. The following ratios deal with the ability of the company to make debt-related payments from the income generated by the company.
DEBT TO EBITDA RATIO
Debt to EBITDA Ratio = Total Liabilties / EBITDA
EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortisation. A higher ratio means that it may take longer to pay back the debt. The ratio gives us some idea about how long it might take for the company to pay off the debts from the generated income.
Net Debt to EBITDA Ratio = (Total Liabilties – Cash and cash equivalents) / EBITDA
This ratio takes into account the cash the company has which can be used to repay part of the debt assuming both the earnings and debt remains unchanged.
INTEREST COVERAGE RATIO
Interest Coverage Ratio = EBIT / Interest Expenses
EBIT stands Earnings before Interest and Tax.
The ratio acts as a margin of safety for a company in terms of payment of interests. A higher ratio shows healthy earnings and lower increases the risk. It is important that we look into the trend in the coverage ratio and do sensitivity analysis to make a judgement. For example, how much the revenue of the company has to go down for the company to be unable to make interest payments. It shows the likelihood of the default of the company.