Written by Gregory Steffens for Gaebler Ventures
Ratio analysis is a fundamental tool for management, investors, or other stakeholders to evaluate the health of a firm's operations. This article introduces you to leverage ratios and how they are calculated.
Leverage ratios are a common benchmark that is considered in even the most rudimentary financial analysis exercises.
Debt and debt to equity ratios are types of leverage ratios that offer different perspectives of the company's financial position.
Let's take a deeper look at these two types of leverage ratios.
A debt ratio measures the amount of leverage used by a particular company to run its operations. For this reason, various stakeholders use the debt ratio to check the long-term solvency of a firm.
Higher ratios, typically over one, indicate that firms have more debt than assets and are at risk for insolvency if obligations come due. Lower ratio percentages point to companies stronger equity positions and can translate into less risky operations. However, lower leveraged positions do not always mean that companies are operating efficiently since tax benefits result from certain levels of debt.
Companies that rely more heavily on equity could be leaving money on the table to the detriment of their owners.
To calculate a firm's debt ratio, divide its total liabilities by its total assets. Both figures can be found on the balance sheet of a company's quarterly or annual reports. For example, if a company has $20,000 worth of liabilities and $25,000 of assets, its debt ratio would be eight tenths or eighty percent. This means that the firm has eighty cents worth of debt for every dollar of its assets.
Debt to Equity
The debt to equity ratio indicates how much of a firm's financing comes from debt as opposed to equity. A company's debt to equity ratio will, most likely, be higher than its debt ratio since it will have more assets than equity investment.
Like debt ratios, higher debt to equity ratios signify that companies have larger amounts of debt versus equity and, therefore, more insolvency risk. Companies with lower ratios have more investments from their shareholders than from suppliers, creditors, and lenders; hence, they are in a better financial position to meet their obligations.
Typically, larger organizations can take on more debt without harming their operations than smaller companies; therefore, the size of the firm should be taken into account when evaluating these ratios.
The calculation of an organizations' debt to equity ratio requires one to divide its total liabilities by its total stockholders' equity. Both these figures are located on the firm's balance sheet included in its annual or quarterly financial statements.
For instance, if a company has $30,000 worth of liabilities and $20,000 of shareholders' equity investment, its debt to equity ratio would be one and a half. This means that creditors have one and a half times as much invested in the company than equity holders.
As with other financial ratios, leverage ratios have the most meaning when comparing a firm's position with those of its competitors in the same industry or sector. Moreover, by comparing a company's current ratios to its historical percentages, stakeholders can evaluate the progress and performance of a company over time.
Gregory Steffens is a talented writer with a strong interest in business strategy and strategic management. He is currently completing his MBA degree, with an emphasis in finance, at the University of Missouri.
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