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Financial Ratios on Assessing The LEVERAGE or GEARING Of A Company
Published by slang April 5th, 2006 in Ratio AnalysisContinued from my last article, we will now look at the financial ratio for assessing the LEVERAGE or gearing of a company. Essentially, the Leverage Financial ratio should be able to measure the amounts of borrowed money being used by the firm.
Leverage Ratios are classified as either:
- Capitalization Ratios, focusing on how investments are financed; or
- Coverage Ratios, focusing on the ability to service the firm’s sources of financing.
| Ratio | DEBT / LEVERAGE / GEARING RATIO |
| Formula | Total Liabilities Total Assets |
| Use | Measures the proportion of total assets financed by debt. |
| Values | Lower is safer |
| Interpretation | • Total liabilities= short term + long term debt • A low ratio may indicate potential to finance new assets with debt |
| Ratio | DEBT-EQUITY RATIO |
| Formula | Total debt Total Equity |
| Use | Measures the extent of debt financing to equity. |
| Values | Varies with industry. <1.1 Strong <2:1 Acceptable <3:1 Evidence of weakness >3:1 Weak >4:1 Problems present >6:1 Likely to fail |
| Interpretation | • A higher ratio means :- -Less long term stability -Higher financial risk -Lower long term debt capacity • Higher business risk requires lower Debt Equity ratio • Distorted by substantial intangible assets and off-balance sheet liabilities • If too low, may be reducing potential Return on Equity |
| Ratio | NET INTEREST COVER / TIMES INTEREST EARNED |
| Formula | EBIT Interest |
| Use | Measures the extent of which earnings are available to meet interest payments |
| Values | Varies with industry. Larger is safer >3:1 Strong >2.5:1 Acceptable >1:1 Evidence of weakness <1:1 Problems present |
| Interpretation | • A lower net interest cover means less earnings are available to meet interest payments and that the business is more vulnerable to increases in interest rates. • Should consider stability and quality of earnings (and cash flow) |
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