Leverage Ratios 

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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
Example of the Use of Financial Leverage and Earnings Company with No Leverage

Company with 50% Leverage
Example of the Use of Financial Leverage and Earnings 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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