Leverage Ratios Meaning and Example
Leverage Ratios Meaning
It refers to the use of debt finance. While debt capital is a cheaper source of finance, it is also a riskier source of finance. Leverage ratios help in assessing the risk arising from the use of debt capital. Two types of ratios are commonly used to analyze financial leverage: structural ratios and coverage ratios.
Structural ratios are based on the proportions of debt and equity in the financial structure of the firm. The structural ratios are: debt-equity ratio and debt-assets ratio. Coverage ratios show the relationship between debt servicing commitments and the sources for meeting these burdens. The important coverage ratios are: interest , fixed charges and debt service coverage ratio.
Leverage Ratios Examples
To get a better picture of Leverage Ratios meaning, let’s discuss the leverage ratios example.
a. Debt equity Ratio:
The debt equity ratio is defined as:
One of the important ratio is debt equity ratio in Leverage ratios. For knowing leverage ratios meaning it is important that measures of leverage ratio should also be understand. The numerator of this ratio consists of all debt, short- term as well as long-term, and the denominator consists of net worth plus preference capital plus deferred tax liability.
In general, the lower the debt-equity ratio, the higher the degree of protection enjoyed by creditors. In using this ratio, however, the following points should be borne in mind:
- The book value of equity may be an understatement of its true value in a period of rising prices. This happens because assets are carried at their historical values less depreciation, not at current values.
- Some forms of debt (like term loans, secured debentures, and secured short-term bank borrowing) are usually protected by charges on specific assets and hence enjoy superior protection.
A Variant of this ratio is total outside liabilities to tangible net worth ratio, which is considered very important by commercial banks. Total outside liabilities are equal to debt, as defined above plus deferred tax liability.
Tangible net worth = paid-up capital + Reserves and surplus – miscellaneous expenditure and losses.
b. Debt-asset Ratio
The debt-asset ratio measures the extent to which borrowed funds support the firm’s assets. It is defined as:
The numerator of this ratio includes all debt, short-term as well as long-term, and the denominator of this ratio is the total of all assets (the balance sheet total).
It is also called the times interest earned and is defined as:
Note that profit before interest and taxes are used in the numerator of this ratio because the ability of a firm to pay interest is not affected by tax payment, as interest on debt funds is a tax deductible expense. A high interest coverage ratio means that the firm can meet its interest burden even if earnings before interest and taxes suffer a considerable decline and vice versa. This ratio is widely used by lenders to assess a debt capacity.
d. Fixed Charges Coverage Ratio
This ratio shows how many times the cash flow before interest and taxes covers all fixed financing charges. It is defined as:
In the denominator of this ratio only the repayment of loan is adjusted upwards for the tax factor because the loan repayment amount, unlike interest, is not tax deductible. Horizon’s tax rate has been assumed to be 50 percent.
This ratio measures debt servicing ability comprehensively because it considers both interest and the principal repayment obligations. The ratio may be amplified to include other fixed charges like lease payment and preference dividends. The fixed charge coverage ratio has to be interpreted with care because short-term loan , funds like working capital loans and commercial paper tend to be self-renewing in nature, hence do not have to be ordinarily repaid from cash flows generated by operations. Hence, a fixed charge coverage ratio of less 1 need not be viewed with much concern.
e. Debt Service Coverage Ratio
Debt Service ratio is among the leverage ratios which is important from the perspective of firm as well as shareholders. It is used by financial institutions in India, the debt service ratio is defined as:
Financial institutions calculate the average debt service ratio for the period during which the term loan for the project is repayable. Normally, financial institutions regard a deb service coverage ratio of 1.5 to 2.0 as satisfactory.