Leverage Ratios

Another important group of detail ratios are Leverage Ratios. Leverage Ratios measure the use of debt and equity for financing of assets. We previously looked at the Financial Leverage Ratio as part of Return on Equity. Three other leverage ratios that we can use are Debt to Equity, Debt Ratio, and Times Interest Earned.

Debt to Equity

Debt to Equity is the ratio of Total Debt to Total Equity. It compares the funds provided by creditors to the funds provided by shareholders. As more debt is used, the Debt to Equity Ratio will increase. Since we incur more fixed interest obligations with debt, risk increases. On the other hand, the use of debt can help improve earnings since we get to deduct interest expense on the tax return. So we want to balance the use of debt and equity such that we maximize our profits, but at the same time manage our risk. The Debt to Equity Ratio is calculated as follows:

Total Liabilities / Shareholders Equity

EXAMPLE - We have total liabilities of $ 75,000 and total shareholders equity of $ 200,000. The Debt to Equity Ratio is 37.5%, $ 75,000 / $ 200,000 = .375. When compared to our equity resources, 37.5% of our resources are in the form of debt.

KEY POINT - As a general rule, it is advantageous to increase our use of debt (trading on the equity) if earnings from borrowed funds exceeds the costs of borrowing.

Debt Ratio

The Debt Ratio measures the level of debt in relation to our investment in assets. The Debt Ratio tells us the percent of funds provided by creditors and to what extent our assets protect us from creditors. A low Debt Ratio would indicate that we have sufficient assets to cover our debt load. Creditors and management favor a low Debt Ratio. The Debt Ratio is calculated as follows:

Total Liabilities / Total Assets

EXAMPLE - Total Liabilities are $ 75,000 and Total Assets are $ 500,000. The Debt Ratio is 15%, $ 75,000 / $ 500,000 = .15. 15% of our funds for assets comes from debt.

NOTE - We use Total Liabilities to be conservative in our assessment.

Times Interest Earned

Times Interest Earned is the number of times our earnings (before interest and taxes) covers our interest expense. It represents our margin of safety in making fixed interest payments. A high ratio is desirable from both creditors and management. Times Interest Earned is calculated as follows: Earnings Before Interest and Taxes / Interest Expense

EXAMPLE - Earnings Before Interest Taxes is $ 100,000 and we have $ 10,000 in Interest Expense. Times Interest Earned is 10 times, $ 100,000 /$ 10,000. We are able to cover our interest expense 10 times with operating income.