Leverage Ratios
Leverage is the use of borrowed funds to acquire assets. During
periods of rising income, the use of borrowed funds can magnify
the increases in returns of a company.
Leverage measures the use of debt to finance a company’s
assets. Although leverage is a major concern for bondholders, who
use leverage ratios to determine the level of debt and the servicing
of the contractual payments of interest and principal, leverage is
also important for common stockholders.
By increasing the use of debt financing, a company can increase
its returns to shareholders. Table 10–7 shows how returns for a company
can increase through the use of leverage (debt financing). This
example illustrates how both the return on equity and the earnings
per share can be increased from 14 to 21 percent and from $1.40 to
$2.10, respectively, by increasing the use of debt financing from 0 to
50 percent of its total assets.
This increase occurs for two reasons. First, the company can
earn more than the 10 percent cost of borrowing. Second, the interest
payments are a tax-deductible expense. The federal government
bears 30 percent (the tax rate used in this example) of the cost of the
interest payments (30 percent of $50, which is $15).
Because the use of debt increases the return to shareholders
as well as the earnings per share, why should shareholders be so
concerned about the level of debt that a company uses to finance its
assets? The answer is that the more debt a company takes on, the
greater is its financial risk and the cost of servicing its debt. If a
downturn in sales takes place, the company might have difficulty
making its interest payments. This situation can lead not only to
defaulting on a loan and, ultimately, to declaration of bankruptcy
but also to significantly reduced returns to shareholders and earnings
per share. Whenever a company increases the amount of its
debt, the costs of raising additional debt issues increase, which
means that the company must earn more than the cost of its
borrowing or it will not see the benefits of leverage. When the level
of debt reaches the point where the earnings on the assets are less
than the costs of the debt, the return on equity and the earnings per
share will decline.
For common stock investors, a highly leveraged company
often indicates that great risk occurs, which requires a greater rate
of return to justify the risk. This increase in the required rate of
return could have a negative effect on the share price. The use of
leverage increases the value of the stock when the level of debt used
is not perceived as adding a great amount of risk to the company.
Table 10-7
Example of the Use of Financial Leverage and Earnings
Company with No Leverage
Company with 50% Leverage
What Is the Optimal Level of Leverage?
All companies use different amounts of leverage, and some industries
typically use more than others. Industries that require large investments
in fixed assets, such as oil companies, airlines, and utilities use
a higher percentage of debt to finance their assets. Banks typically
also use large amounts of debt because deposits finance their assets;
this leverage results in large fluctuations in the banking industry’s
earnings whenever slight fluctuations in revenues occur.
When you are considering the leverage of one company, compare
it with the typical leverage for the industry. Investors should
look at a company’s debt and coverage ratios to see the extent of its
borrowing and its ability to service the debt.
Debt Ratio
The debt ratio measures a company’s use of debt as a percentage of
total assets. The debt ratio indicates how much of the financing of
the total assets comes from debt.
Debt ratio = total current plus noncurrent liabilities/total assets
Compare the debt ratio with the average of the industry to get
a better feeling for the degree and extent of the company’s leverage.
Acompany with a large debt ratio becomes increasingly vulnerable
if a downturn in sales or the economy occurs, particularly in the
latter case if it is a cyclical company.
When you examine a company’s financial statements, you
should always check the footnotes to see whether any debt has
been excluded from the balance sheet. If a company does not consolidate
its financial subsidiaries into its financial statements, any
debt the parent company is responsible for is reported in the footnotes
to the financial statements.
Debt-to-Equity Ratio
The debt-to-equity ratio measures a company’s use of debt as a percentage
of equity. The debt-to-equity ratio is computed by dividing
the total debt by the company’s shareholders’ equity. The higher
the ratio, the greater is the level of financing provided by debt, and
the lower the ratio the greater is the level of financing provided by
shareholders. This ratio is similar to the total debt ratio.
Coverage Ratio
The coverage ratio is a measure of a company’s ability to service its
debt commitments (cover its interest payments). The times interest
earned ratio measures a company’s coverage of its interest payments.
It is calculated as follows:
Times interest earned ratio =
earnings before interest and taxes (EBIT)/annual interest expense
For example, if a company has a times interest earned ratio of 1.12,
you would want to know how much leeway the company has with
a downturn in its earnings before interest and taxes before it will
not have sufficient earnings to cover its interest payments. You
compute the margin of safety of the coverage ratio as follows:
Margin of safety of the coverage ratio = 1 – (1/coverage ratio)
Acompany with a coverage ratio of 1.12 would have a margin
of safety of 10.71 percent:
1 – (1/1.12) = 10.71%
The company’s EBIT can fall by only 10.71 percent before the earnings
coverage is insufficient to service its debt commitments.
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