Businesses use debt to finance operations. Financial leverage ratios measure the extent to its use. More leverage becomes problematic in a business downturn if profitability (or operating losses) are not sufficient to cover debt servicing requirements (periodic repayments of the debt and loan agreement covenants).
It is a risk to carry too much debt. However, the use of debt can act as an earnings accelerator when times are good. In addition, financing operations with debt preserves the use of the company’s ownership equity, which is an important consideration to shareholders and the value of their shares in the business.
Some well-known ratios:
- Debt to Equity = [Total Liabilities] / [Shareholders’ Equity]
- Generally, a ratio greater than two is considered risky to investors in the stock, and to lenders; but this varies by industry.
- Debt to Capital = [Total Liabilities] / [Total Liabilities + Shareholders’ Equity]
- Measures the % of debt in the company’s capital structure.
- Operating leases are capitalized and counted as debt, and preferred shares and minority interest are counted in equity to get a complete picture of the company’s leverage.
- Degree of Financial Leverage = [% Change in EPS] / [% Change in EBIT]
- EPS = (Net) Earnings Per Share
- EBIT = Earnings Before Interest and Taxes (generally, operating earnings)
- Measures the sensitivity of EPS to operating earnings, which is affected by the use of leverage.
- Debt to EBITDA = [Total Debt] / EBITDA
- EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization
- EBITDA is a measure of cash generated by the business which is available to pay the debt servicing requirements.
- Banks often use this measurement (and set specific targets) in the loan agreement (called covenants) with the company.
- The higher this ratio, the greater the risk to the lender. So it is watched and is important in banking.
- Quick Ratio = [Cash + A/R + Marketable Securities] / [Current Liabilities]
- Measures a company’s most liquid position. Used to evaluate the company’s ability to quickly pay off any and all its current bills. Its also known as the “Acid Test” and provides a general indicator of how well the company is prepared to service its operating needs.
- A ratio of 1.0+ is considered healthy. However, too much in Accounts Receivables (A/R) could artificially bump up this ratio. If a lot of that A/R is with a few customers, there could still be problems to liquidity if certain customers delay their payments to the company. SO the “age” and payment terms of the receivables should be considered as well when determining what a healthy Quick Ration might be for the company.