LEVERAGE RATIOS:
The third classification of ratios are known as Leverage Ratios. Both long-term and short-term creditors are concerned with the amount of leverage a company employs, since it indicates the firm's risk exposure in meeting its debt obligations. The most common leverage ratios include; debt ratio, and debt to equity ratio. Lets look at each ratio separately, beginning with the debt ratio.
DEBT RATIO:
The debt ratio measures the extent to which borrowed funds have been used to finance a company's operation. Below depicts how the debt ratio is calculated.
Debt Ratio | = | Total Debt Total Assets |
= | $44,875 $77,695 |
= | 0.58 |
As you can see, two values are needed to calculate the debt ratio. Total Debt is better known as the amount a company owes to all its creditors. These include all current liabilities and long-term liabilities (economic burdens). Total assets, in their simplest form, represent all the items a company owns (economic resources).
Both figures needed in calculating the debt ratio can be found on a company's balance sheet under the sections entitled total liabilities and total assets. Therefore, the Widget Manufacturing Company would refer to the following section of its balance sheet when calculating the December 31, 200Y debt ratio.
ASSETS: | LIABILITIES: | |||
Current Assets: | Current Liabilities: | |||
Cash | $ 2,550 | Accounts Payable | $ 9,500 | |
Marketable securities | $ 2,000 | Short-term Bank Loan | $11,375 | |
Account Receivable (Net) | $16,675 | Total Current Liabilities | $20,875 | |
Inventories | $26,470 | |||
Total Current Assets | $47,695 | Total Long Term Debt | $24,000 | |
TOTAL LIABILITIES | $44,875 | |||
Fixed Assets: | ||||
Plant & Equipment | $41,000 | |||
Less: Accumulated Depreciation | $11,000 | |||
Net Plant & Equipment | $30,000 | |||
TOTAL ASSETS | $77,695 |
As you can see, Total Current Liabilities are $20,875 while Total Long-term Liabilities are $24,000. Together, total liabilities or total debt for the company as of December 31, 200Y is $44,875. The total assets are comprised of current assets and fixed assets. Therefore, the company's total assets as of December 31, 200Y are $77,695. The company would calculate its debt ratio as of December 31, 200Y as follows;
Debt Ratio | = | Total Debt Total Assets |
= | $44,875 $77,695 |
= | 0.58 |
The debt ratio for the Widget Manufacturing Company is 0.58. This means, 58% of the company's total assets are financed through creditors such as banks, suppliers of inventory, loans from family members, government (taxes payable), shareholders (dividends payable), and any other type of debt the company may have. Also, we may look at the debt ratio from a dollar point of view by saying; for every $0.58 cents the company owes, it owns $1.00 worth of assets.
As you might suspect, the lower the debt ratio, the more stable a company is considered. Moreover, if your company owes less debt, in relation to a competitor, for example, then your financial position is stronger and more stable. On the other hand, the higher a company's debt ratio, the more money it owes, and therefore the less stable the company appears. Moreover, companies with high debt ratios generally pay more interest on borrowed funds which reduces their net income. In addition, more cash is required to pay the monthly principal and interest payments associated with the debt.
DEBT-TO-EQUITY RATIO:
The second leverage ratio is known as the debt-to-equity ratio. The debt-to-equity ratio measures the "investments" provided by creditors versus the investments provided by the company's owners. Below depicts how the debt-to-equity ratio is calculated;
Debt-to-Equity | = | Total Debt Total Equity |
As you can see, two values are needed to calculate the debt-to-equity ratio. As indicated earlier, total debt is better known as the amount a company owes to all its creditors. These include all current liabilities and all long-term liabilities. The total equity represents all the investments made by the owners of the company.
Both items needed in calculating the debt-to-equity ratio can be found on a company's balance sheet under the sections entitled, "total liabilities" and "total equity". Therefore, the Widget Manufacturing company would refer to the following section of its balance sheet when calculating its December 31, 200Y debt-to-equity ratio.
LIABILITIES: | |
Current Liabilities: | |
Accounts Payable | $ 9,500 |
Short-term Bank Loan | $11,375 |
Total Current Liabilities | $20,875 |
Total Long Term Debt | $24,000 |
TOTAL LIABILITIES | $44,875 |
EQUITY: | |
Common Shares | $25,000 |
Retained Earnings | $ 7,820 |
TOTAL EQUITY | $32,820 |
Total Liabilities & Equity | $77,695 |
As you can see, Total Current Liabilities are $20,875 while Total Long-term Liabilities are $24,000. Together, the total liabilities or total debt for the company as of December 31, 200Y is $44,875. The total equity for our example is comprised of the common shares of $25,000 and retained earnings of $7,820. Therefore, total equity as of December 31, 200Y is $32,820. The Widget Manufacturing Company would calculate their debt-to-equity ratio as of December 31, 200Y as follows;
Debt-to-Equity | = | Total Debt Total Equity |
= | $44,875 $32,820 |
= | 1.37 |
As you can see, the debt-to-equity ratio is 1.37. This means that for every $1.00 invested by the owners of the company, creditors (such as banks, suppliers of product, vendors, and other entities the company owes) have invested $1.37
Note: the lower the debt-to-equity ratio, the more stable a company is considered. Moreover, if your company owes less debt, in relation to a competitor, for example, then your financial position is stronger and more stable. On the other hand, the higher a company's debt-to-equity ratio, the more money it owes, and therefore the less stable the company appears. In a nutshell, we can say that the Widget Company's creditors have invested more into the operation than the company's owners.
Leverage Ratio Summary:
In summary, the leverage ratios consist of the debt ratio and the debt-to-equity ratio. The debt ratio is calculated by dividing a company's total debt by the company's total assets. The debt-to-equity ratio is calculated by dividing a company's total debt by the company's total equity. Below summarizes the debt ratio and the debt-to-equity ratio for the Widget Manufacturing Company as of December 31, 200Y;
Debt Ratio | = | Total Debt Total Assets |
= | $44,875 $77,695 |
= | 0.58 |
Debt-to-Equity | = | Total Debt Total Equity |
= | $44,875 $32,820 |
= | 1.37 |