Leverage ratio is one of the most important of the financial ratios as it determines how much of the capital that is present in the company is in the form of debts. It also analyses how the company is able to meet its obligations.
Leverage ratio becomes more critical as it analyzes the capital structure of the company and the way it can manage its capital structure so that it can pay off the debts.
Let us look at some of the leverage ratios that are generally used
There are two broad types of leverage ratios which are:
- Capital Structure Ratio
- Coverage Ratio
Capital Structure Ratio
Capital structure ratio is used to determine the financing strategy that is used so that the company can focus on the long term solvency.
The ratios that fall under the capital structure ratio are:
i. Equity Ratio
ii. Debt Ratio
iii. Debt to equity ratio
i. Equity ratio
This is used to calculate the amount of assets that are funded by the owners investments. It shows what portion of the assets of the company is being financed by investors and how much leveraged a company is by using debt.
It is calculated as follows
Equity Ratio = Total Equity/ Total Assets
Or it can be calculated as
Equity Ratio = Shareholder Equity/ Total Capital Employed
A higher equity ratio shows to potential investors that existing investors have trust in the company and are willing to invest further in the company.
ii. Debt Ratio
Debt ratio is a type of financial ratio that is useful in calculating the extent of financial leverage a firm is utilising. It is represented in percentage and is very useful in understanding the proportion of assets which are financed by debt.
The formula for calculating debt ratio is
Debt Ratio = Total Debt / Total Assets
Where total debt = Short Term and Long Term Borrowings, Debentures and Bonds
A higher debt ratio is usually an indicator of high financial risk but many firms use high debts to generate more business. If the profit earned from using the debt is more than the interest needed for repaying the debt, it is said to be profitable for the business.
iii. Debt to Equity Ratio
This ratio calculates the proportion of debt and equity that a company uses for funding the operations of the business. It is an important financial ratio that shows how a company is funding its operations.
It is calculated by the following formula
Debt to equity ratio = Total Debt/ Shareholders Fund
Or
Debt to equity ratio = Total Liabilities / Total Shareholders equity.
D/E ratio or Debt to equity ratio is different for different kinds of industries. It is more in companies requiring high amounts of debt.
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Coverage Ratios
Coverage ratios determine the ability of a company to meet its debt obligations which include interest payments or dividends. A higher coverage ratio makes it easier for a business to pay off the dividends and interest payments.
Let us discuss the types of coverage ratios here
i. Debt Service Coverage Ratio
ii. Interest coverage ratio
iii. Capital gearing ratio
i. Debt service coverage ratio or DSCR
Debt service coverage ratio is used in corporate finance to determine the cash flow available to business which can be used for clearing off the current debt obligations which are in the form of interest payments or dividends or sinking funds etc.
It is calculated by the following formula
Debt service coverage ratio = Net Operating Income / Total Debt Service
Where Total Debt service is the current debt obligations that a company owes.
A ratio of 1.5 to 2 is regarded as an idea ratio for a company while a value which is less than 1 is indicative of a negative cash flow which makes a company more vulnerable to being unable to clear current debt obligations.
ii. Interest Coverage Ratio
Interest coverage ratio is a financial ratio that is used by investors to determine how easily a company is able to clear off the interest. It is calculated by dividing a company’s EBIT which refers to Earnings before Interest and Taxes by interest payments that are due in the current accounting period.
It is shown as
Interest Coverage Ratio = EBIT / Interest Due
It is a margin of safety that a company should have for paying its debts within the given accounting period.
iii. Capital Gearing Ratio
Capital gearing ratio is a critical ratio that helps in evaluating the financial health of the company. This ratio calculates the capital structure of the company and analyses the proportion of debts and equity. Debt is a low cost option but will put more burden as a liability in the financial statements of the company.
Capital gearing ratio ratio measures the impact that debt has on the company’s capital structure.
It can be calculated by the following formula
Capital gearing ratio = Common stockholders equity / Fixed cost bearing funds
This article will help the students in developing their concept knowledge in the areas of ratios that are used for analysing the financial statements and position of the company. For more such interesting articles, stay tuned to BYJU’S.
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