Financial Leverage Ratios to Measure the Solvency of Your Business
Financial leverage ratios are also called debt ratios. You may also find them called long-term solvency ratios. They measure the ability of the business to meet its long-term debt obligations, such as interest payments on debt, the final principal payment on the debt, and any other fixed obligations like lease payments. Long-term debt is defined as obligations to repay with a maturity of more than one year.
These ratios compare the overall debt load of a company to its assets or equity, showing how much of the company assets below to shareholders vs. creditors. If shareholders own more assets, the company is said to be less leveraged. If creditors own a majority of assets, the company is said to be highly leveraged. Clearly, financial leverage ratios help management and investors to understand how risk level of the capital structure of a company.
Let's look at a few of the most important.
The debt ratio measures a company's total liabilities against its total assets and is expressed as a percentage. It implies the company's ability to satisfy its liabilities with its assets, or how many assets the company must sell to pay all its liabilities. It shows the company's overall debt burden.
The debt ratio is calculated by dividing total liabilities by total assets. Both of these numbers can easily be found on the balance sheet. A lower ratio, .5% or less, is seen as favorable, indicating stability and longevity. A ratio of 1 means that total liabilities equals total assets. In other words, the company would have to sell off all of its assets in order to pay off its liabilities.
Debt to Equity Ratio
The debt to equity ratio compares a company's total debt to total equity, indicating the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders).
The debt to equity ratio is calculated by dividing total liabilities by total equity. The debt to equity ratio is considered a balance sheet ratio because all of the elements are reported on the balance sheet. A debt to equity ratio of 1 would mean that investors and creditors have an equal stake in the business assets. A lower debt to equity ratio usually implies a more financially stable business.
The Equity ratio measures the amount of assets that are financed by owners' investments by comparing the total equity in the company to the total assets. In other words, after all of the liabilities are paid off, how much of the remaining assets the investors will end up with. The equity ratio also measures how much of a firm's assets were financed by investors, or the investors' stake in the company.
The equity ratio is calculated by dividing total equity by total assets. All of the assets and equity reported on the balance sheet are included in the equity ratio calculation. A higher equity ratio is seen as favorable because it shows that investors have confidence and are willing to back this company and that the company is more sustainable and less risky.
These financial leverage ratios allow the owner of the business to determine how well the business can meet its long-term debt obligations. These ratios are worth nothing, or very little, in isolation. You have to be able to do trend and industry analysis to be able to determine how well you are managing your debt position.