Leverage Ratios - Corporate Finance Institute

List of common leverage ratios · Debt-to-Assets Ratio = Total Debt / Total Assets · Debt-to-Equity Ratio = Total Debt / Total Equity · Debt-to-Capital Ratio = ... LeverageRatiosAclassofratiosthatmeasuretheindebtednessofafirmHome›Resources›Knowledge›Finance›LeverageRatiosWhatareLeverageRatios?AleverageratioisanykindoffinancialratioFinancialAnalysisRatiosGlossaryGlossaryoftermsanddefinitionsforcommonfinancialanalysisratiosterms. It'simportanttohaveanunderstandingoftheseimportantterms.thatindicatesthelevelofdebtincurredbyabusinessentityagainstseveralotheraccountsinitsbalancesheetBalanceSheetThebalancesheetisoneofthethreefundamentalfinancialstatements.Thefinancialstatementsarekeytobothfinancialmodelingandaccounting.,incomestatementIncomeStatementTheIncomeStatementisoneofacompany'scorefinancialstatementsthatshowstheirprofitandlossoveraperiodoftime. Theprofitor,orcashflowstatementCashFlowStatement​AcashflowStatementcontainsinformationonhowmuchcashacompanygeneratedandusedduringagivenperiod.. Theseratiosprovideanindicationofhowthecompany’sassetsandbusinessoperationsarefinanced(usingdebtorequity).Belowisanillustrationoftwocommonleverageratios:debt/equityanddebt/capital.  ListofcommonleverageratiosThereareseveraldifferentleverageratiosthatmaybeconsideredbymarketanalysts,investors,orlenders.Someaccountsthatareconsideredtohavesignificantcomparabilitytodebtaretotalassets,totalequity,operatingexpenses,andincomes.Beloware5ofthemostcommonlyusedleverageratios:Debt-to-AssetsRatio=TotalDebt/TotalAssetsDebt-to-EquityRatio=TotalDebt/TotalEquityDebt-to-CapitalRatio=TodayDebt/(TotalDebt+TotalEquity)Debt-to-EBITDARatio=TotalDebt/EarningsBeforeInterestTaxesDepreciation&Amortization(EBITDAEBITDAEBITDAorEarningsBeforeInterest,Tax,Depreciation,Amortizationisacompany'sprofitsbeforeanyofthesenetdeductionsaremade.EBITDAfocusesontheoperatingdecisions)Asset-to-EquityRatio=TotalAssets /TotalEquity Leverageratioexample#1Imagineabusinesswiththefollowingfinancialinformation:$50millionofassets$20millionofdebt$25millionofequity$5millionofannualEBITDA$2millionofannualdepreciationexpenseNowcalculateeachofthe5ratiosoutlinedaboveasfollows:Debt/AssetsDebttoAssetRatioThedebttoassetratio,alsoknownasthedebtratio,isaleverageratiothatindicatesthepercentageofassetsthatarebeingfinancedwithdebt.=$20/$50=0.40xDebt/EquityFinanceCFI'sFinanceArticlesaredesignedasself-studyguidestolearnimportantfinanceconceptsonlineatyourownpace.Browsehundredsofarticles!=$20/$25=0.80xDebt/Capital=$20/($20+$25)=0.44xDebt/EBITDADebt/EBITDARatioThenetdebttoearningsbeforeinterest,taxes,depreciation,andamortization(EBITDA)ratiomeasures financialleverage andacompany’sabilitytopayoffitsdebt.Essentially,thenetdebttoEBITDAratio(debt/EBITDA)givesanindicationastohowlongacompanywouldneedtooperateatitscurrentleveltopayoffallitsdebt.=$20/$5=4.00xAsset/Equity=$50/$25=2.00x  DownloadtheFreeTemplateEnteryournameandemailintheformbelowanddownloadthefreetemplatenow! LeverageRatiosTemplateDownloadthefreeExceltemplatenowtoadvanceyourfinanceknowledge!FirstName*Email*Δ Leverageratioexample#2Ifabusinesshastotalassetsworth$100million,totaldebtof$45million,andtotalequityof$55million,thentheproportionateamountofborrowedmoneyagainsttotalassetsis0.45,orlessthanhalfofitstotalresources.Whencomparingdebttoequity,theratioforthisfirmis0.82,meaningequitymakesupamajorityofthefirm’sassets. ImportanceandusageLeverageratiosrepresenttheextenttowhichabusinessisutilizingborrowedmoney.Italsoevaluatescompanysolvencyandcapitalstructure.Havinghighleverageinafirm’scapitalstructurecanberisky,butitalsoprovidesbenefits.Theuseofleverageisbeneficialduringtimeswhenthefirmisearningprofits,astheybecomeamplified.Ontheotherhand,ahighlyleveredfirmwillhavetroubleifitexperiencesadeclineinprofitabilityandmaybeatahigherriskofdefaultthananunleveredorlessleveredfirminthesamesituation.Finally,analyzingtheexistinglevelofdebtisanimportantfactorthatcreditorsconsiderwhenafirmwishestoapplyforfurtherborrowing.Essentially,leverageaddsriskbutitalsocreatesarewardifthingsgowell. Whatarethevarioustypesofleverageratios? 1.OperatingleverageAnoperatingleverageratioreferstothepercentageorratiooffixedcoststovariablecosts.Acompanythathashighoperatingleveragebearsalargeproportionoffixedcostsinitsoperationsandisacapitalintensivefirm.Smallchangesinsalesvolumewouldresultinalargechangeinearningsandreturnoninvestment.Anegativescenarioforthistypeofcompanycouldbewhenitshighfixedcostsarenotcoveredbyearningsbecausethemarketdemandfortheproductdecreases.Anexampleofacapital-intensivebusinessisanautomobilemanufacturingcompany.Iftheratiooffixedcoststorevenueishigh(i.e.,>50%) thecompanyhassignificantoperatingleverage. Iftheratiooffixedcoststorevenueislow(i.e.,<20%)thecompanyhaslittleoperatingleverage. 2.FinancialleverageAfinancialleverageratioreferstotheamountofobligationordebtacompanyhasbeenorwillbeusingtofinanceitsbusinessoperations.Usingborrowedfunds,insteadofequityfunds,canreallyimprovethecompany’sreturnonequityandearningspershare,providedthattheincreaseinearningsisgreaterthantheinterestpaidontheloans.Excessiveuseoffinancingcanleadtodefaultandbankruptcy. Seethemostcommonfinancialleverageratiosoutlinedabove. 3.CombinedleverageAcombinedleverageratioreferstothecombinationofusingoperatingleverageandfinancialleverage.Forexample,whenviewingthebalancesheetandincomestatement,operatingleverageinfluencestheupperhalfoftheincomestatementthroughoperatingincomewhilethelowerhalfconsistsoffinancialleverage,whereinearningspersharetothestockholderscanbeassessed. Howisleveragecreated?Leverageiscreatedthroughvarioussituations:Acompanytakesondebttopurchasespecificassets.Thisisreferredtoas“asset-backedlending”andisverycommoninrealestateandpurchasesoffixedassetslikeproperty,plant,andequipmentPP&E(Property,PlantandEquipment)PP&E(Property,Plant,andEquipment)isoneofthecorenon-currentassetsfoundonthebalancesheet.PP&EisimpactedbyCapex,(PP&E).Acompanyborrowsmoneybasedontheoverallcreditworthinessofthebusiness.Thisisusuallyatypeof“cashflowloan”andisgenerallyonlyavailabletolargercompanies.Whenacompanyborrowsmoneytofinanceanacquisition(learnmoreaboutthemergersandacquisitionsprocessMergersAcquisitionsM&AProcessThisguidetakesyouthroughallthestepsintheM&Aprocess.Learnhowmergersandacquisitionsanddealsarecompleted.Inthisguide,we'lloutlinetheacquisitionprocess).Whenaprivateequityfirm(orothercompany)doesaleveragedbuyoutLeveragedBuyout(LBO)Aleveragedbuyout(LBO)isatransactionwhere abusinessisacquiredusingdebtasthemainsourceofconsideration.(LBO).Whenanindividualdealswithoptions,futures,margins,orotherfinancialinstruments.Whenapersonpurchasesahouseanddecidestoborrowfundsfromafinancialinstitutiontocoveraportionoftheprice.Ifthepropertyisresoldatahighervalue,againisrealized.Equityinvestorsdecidetoborrowmoneytoleveragetheirinvestmentportfolio.AbusinessincreasesitsfixedcostsFixedandVariableCostsCostissomethingthatcanbeclassifiedinseveralwaysdependingonitsnature.Oneofthemostpopularmethodsisclassificationaccordingtoleverageitsoperations.Fixedcostsdonotchangethecapitalstructureofthebusiness,buttheydoincreaseoperatingleveragewhichwilldisproportionatelyincrease/decreaseprofitsrelativetorevenues. Whataretherisksofhighoperatingleverageandhighfinancialleverage?Ifleveragecanmultiplyearnings,itcanalsomultiplyrisk.Havingbothhighoperatingandfinancialleverageratioscanbeveryriskyforabusiness. Ahighoperatingleverageratioillustratesthatacompanyisgeneratingfewsales,yethashighcostsormarginsthatneedtobecovered.Thismayeitherresultinalowerincometargetorinsufficientoperatingincometocoverotherexpensesandwillresultinnegativeearningsforthecompany.Ontheotherhand,highfinancialleverageratiosoccurwhenthereturnoninvestment(ROI)doesnotexceedtheinterestpaidonloans.Thiswillsignificantlydecreasethecompany’sprofitabilityandearningspershare.  CoverageratiosBesidestheratiosmentionedabove,wecanalsousethecoverageratiosCoverageRatioACoverageRatioisusedtomeasureacompany’sabilitytopayitsfinancialobligations.Ahigherratioindicatesagreaterabilitytomeetobligationsinconjunctionwiththeleverageratiosto measureacompany’sabilitytopayits financialobligationsDebtCapacityDebtcapacityreferstothetotalamountofdebtabusinesscanincurandrepayaccordingtothetermsofthedebtagreement..Themostcommoncoverageratiosare:InterestcoverageratioInterestCoverageRatioInterestCoverageRatio(ICR)isafinancialratiothatisusedtodeterminetheabilityofacompanytopaytheinterestonitsoutstandingdebt.: Theabilityofacompanytopaythe interestexpenseInterestExpenseInterestexpensearisesoutofacompanythatfinancesthroughdebtorcapitalleases.Interestisfoundintheincomestatement,butcanalso (only)onitsdebtDebtservicecoverageratio:Theabilityofacompanytopayalldebtobligations,includingrepaymentofprincipalandinterestCashcoverageratio: TheabilityofacompanytopayinterestexpensewithitscashbalanceAssetcoverageratio: Theabilityofacompanytorepayitsdebtobligationswithitsassets AdditionalResourcesThisleverageratioguidehasintroducedthemainratios,Debt/Equity,Debt/Capital,Debt/EBITDA,etc.BelowareadditionalrelevantCFIresourcestohelpyouadvanceyourcareer.CoverageRatiosCoverageRatioACoverageRatioisusedtomeasureacompany’sabilitytopayitsfinancialobligations.AhigherratioindicatesagreaterabilitytomeetobligationsValuationMultiplesMultiplesAnalysisThemultiplesanalysisisavaluationtechniquethatutilizesdifferentfinancialmetricsfromcomparablecompaniestovalueatargetcompany.EV/EBITDAEV/EBITDAEV/EBITDAisusedinvaluationtocomparethevalueofsimilarbusinessesbyevaluatingtheirEnterpriseValue(EV)toEBITDAmultiplerelativetoanaverage.Inthisguide,wewillbreakdowntheEV/EBTIDAmultipleintoitsvariouscomponents,andwalkyouthroughhowtocalculateitstepbystepFinancialmodelingguideFreeFinancialModelingGuideThisfinancialmodelingguidecoversExceltipsandbestpracticesonassumptions,drivers,forecasting,linkingthethreestatements,DCFanalysis,moreGetCertifiedfor
FinancialModeling(FMVA)®Gainin-demandindustryknowledgeandhands-onpracticethatwillhelpyoustandoutfromthecompetitionandbecomeaworld-classfinancialanalyst.LearnMoreCorporateFinanceInstituteBacktoWebsite0searchresultsfor‘’Peoplealsosearchfor:excelFreefreecoursesaccountingBalancesheetDCFIRRExploreOurCertificationsFinancialModeling&ValuationAnalyst(FMVA)®LearnmoreCommercialBanking&CreditAnalyst(CBCA)™LearnmoreCapitalMarkets&SecuritiesAnalyst(CMSA)®LearnmoreCertifiedBusinessIntelligence&DataAnalyst(BIDA)™LearnmoreResourcesExcelShortcutsPCMacListofExcelShortcuts Excelshortcuts-Itmayseemsloweratfirstifyou'reusedtothemouse,butit'sworththeinvestmenttotakethetimeand...FreeFinancialModelingGuideACompleteGuidetoFinancialModeling Thisresourceisdesignedtobethebestfreeguidetofinancialmodeling!Wewillbreakdownthemostimportant...SQLDataTypesWhatareSQLDataTypes? TheStructuredQueryLanguage(SQL)comprisesseveraldifferentdatatypesthatallowittostoredifferenttypesofinformation...StructuredQueryLanguage(SQL)WhatisStructuredQueryLanguage(SQL)? StructuredQueryLanguage(SQL)isaspecializedprogramminglanguagedesignedforinteractingwithadatabase....SeeAllResourcesSeeAllPopularCoursesFree!FMVA®-PrepCourses3.5hExcelFundamentals-FormulasforFinanceFMVA®-Required5.5hBuildinga3StatementFinancialModelFMVA®-Required7.5hBusinessValuationModelingPartIFMVA®-Required2.5hScenario&SensitivityAnalysisinExcelFMVA®-Required6hDashboards&DataVisualizationFMVA®-Electives11hLeveragedBuyoutLBOModelingSeeAllCoursesSeeAllRecentSearchesSuggestionsFreeCoursesExcelCoursesFinancialModeling&ValuationAnalyst(FMVA)®