Continued 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) |
- Financial Ratios on Assessing The MARKET VALUE Of A Company
- Financial Ratios On The Assessing Of The Profitability Of A Company
- Gearing- Determinants &Its Advantages And Disadvantages
- Financial Ratio on Assessing The Liquidity Of A Company
- Financial Ratio on Assessing The ACTIVITY Of Assets Utilised
- Ratio Analysis:Which Ratios Have the Most Value?
- DuPont System:A Matter of Leverage or Is It FINANCIAL EFFICIENCY?
FCCA,CA(MIA)with more than 26 years of post-qualifying working experiences. Previous working stints with one of the big accounting four,Regional GFC & Group Treasurer in a group of Malaysian and Group CFO in Singapore public listed concern.Also author to another very popular free educational accounting cum finance blog:http://basiccollegeaccounting.com under the branding of College Accounting Coach.
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