In physics, leverage refers to a multiplication of force. Using a lever and fulcrum, you can press down on one end of a lever with a given force, and get a larger force at the other end. The amount of leverage depends on the length of the lever and the position of the fulcrum. In finance, leverage refers to a multiplication of changes in profitability measures. For example: a 10% increase in sales might lead to a 20% increase in net income. The amount of leverage depends on the amount of debt that a firm uses to finance its operations, so a firm which uses a lot of debt is said to be “highly leveraged.”
Leverage ratios describe the degree to which the firm uses debt in its capital structure. This is important information for creditors and investors in the firm:
- Creditors might be concerned that a firm has too much debt and will therefore have difficulty in repaying loans.
- Investors might be concerned because a large amount of debt can lead to a large amount of volatility in the firm’s earnings.
However, most firms use some debt. This is because the tax deductibility of interest can increase the wealth of the firm’s shareholders. We will examine several ratios that help to determine the amount of debt that a firm is using. How much is too much depends on the nature of the business.
The Total Debt Ratio
The total debt ratio measures the total amount of debt (long-term and short-term) that the firm uses to finance its assets:
Calculating the total debt ratio for ROYAL BALI CEMERLANG, we find that debt makes up about 58.45% of their capital structure:
Total Debt Ratio = ————– = 58.45%
The result for 2004 is 58.45% which is higher than the 54.81% in 2003.
The Long-Term Debt Ratio
Many analysts believe that it is more useful to focus on just the long-term debt (LTD) instead of total debt. The long-term debt ratio is the same as the total debt ratio, except that the numerator includes only long-term debt:
Long-Term Debt Ratio = —————————
ROYAL BALI CEMERLANG’s long-term debt ratio is:
Long-Term Debt Ratio = ——————- = 25.72%
Revealed that in 2003 the ratio was only 22.02%. Obviously, ROYAL BALI CEMERLANG has increased its long-term debt at a faster rate than it has added assets.
The Long-Term Debt to Total Capitalization Ratio
Similar to the previous two ratios, the long-term debt to total capitalization ratio tells us the percentage of long-term sources of capital that is provided by long-term debt (LTD). It is calculated by:
LTD to Total Capitalization = ——————————————————–
LTD+Preferred Equity+Common Equity
For ROYAL BALI CEMERLANG, we have:
LTD to Total Capitalization = ———————————– = 38.23%
424.61 + 685.99
Since ROYAL BALI CEMERLANG has no preferred equity, its total capitalization consists of long-term debt and common equity. Note that common equity is the total of common stock and retained earnings. In 2003 this ratio was only 32.76%
The Debt to Equity Ratio
The debt to equity ratio provides exactly the same information as the total debt ratio, but in a slightly different form that some analysts prefer:
Debt to Equity = ———————-
For ROYAL BALI CEMERLANG, the debt to equity ratio is:
Debt to Equity = —————— = 1.41 times
Found that the debt to equity ratio in 2003 was 1.21 times.
To see that the total debt ratio and the debt to equity ratio provide the same information, realize that:
Total Debt Total Debt Total Asset
—————— = ————————— x —————————
Total Equity Total Asset Total Equity
But from rearranging equation (4-8) we know that:
Total Asset 1
——————- = —————————-
Total Equity 1 – Total Debt Ratio
So, by substitution we have:
Total Debt Total Debt 1
——————– = —————— x ————————————–
Total Equity Total Asset 1 – (Total Debt/Total Asset)
We can convert the total debt ratio into the debt to equity ratio without any additional information (the result is not exact due to rounding):
Total Debt 1
——————- = 0.5845 x ———————– = 1.41
Total Equity 1 – 0.5845
The Long-Term Debt to Equity Ratio
Once again, many analysts prefer to focus on the amount of long-term debt that a firm carries. For this reason, many analysts like to use the long-term debt to total equity ratio:
Long-Term Debt to Equity = —————————————————–
Preferred Equity + Common Equity
ROYAL BALI CEMERLANG’s long-term debt to equity ratio is:
Long-Term Debt to Equity = ————————– = 61.90%
Note that the ratio was only 48.73% in 2003.