How To Use Leverage Ratios In Financial Analysis

leverage ratio

A leverage ratio is a simple measure of a company that tells a complex story. One cannot properly evaluate a firm without it.

What Is A Leverage Ratio?

 

leverage ratio
A Leverage Ratio Measures A Firm’s Potential Risk

A leverage ratio is a expression of a firm’s capital structure. Furthermore, companies either use all debt financing, all equity financing, a mix of both. Choices of capital structure comes from management. For example, the best management use the capital structure that makes the firm most valuable.

Additionally, a number of these ratios exist. Listed in no order, some include: Debt:Asset, Debt/Equity, Debt/Capital (Debt/ (Debt + Equity), or Asset/Equity.

The most popular leverage ratios are Debt/Equity and Debt/Capital. Some consider a Debt/Equity ratios over 2 risky. However, leverage ratios fluctuate with industry.

Leverage Ratio In Analysis

Being debt-free is not always the best scenario for companies. If a company earns a return higher than their interest on the loan, the company grows profits. However, if leverage becomes excessive, the firm experiences bankruptcy risk. This happens when companies cannot pay back their loans.

Also, how does one know when a company is over leveraged? Leverage ratios vary across industries, but provide value when compared within industries. For example, utility companies typically use more debt than  internet companies. Utility companies require large capital outlays for new plants and equipment, and see relatively more stable cash flow.

Standard debt/capital ratios stand at .05 or lower.

Understanding Leverage Ratios

Why do these measures concern investors? During invariable economic downturns, cash strapped companies cannot pay interest expenses. This creates a panic situation, and share prices typically suffer, creating a perfect storm.

Unfortunately, this situation unfolded in 2008 in the American economy. Banks became over leveraged on certain insurance policies, which created a viscous circle of bad debts.

Final Thoughts

Finally, leverage ratios are critical in financial analysis. In fact, they should be viewed first when taking risk measures of a company. The greatest management vision cannot survive overbearing debt loads.

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