Companies make use
of debt capital to finance their assets. Financial leverage refers to the degree
of debt capital in the capital structure. It is believed that a certain level of
debt is desirable as it can be beneficial to the business. However, presence of
a debt element in the capital structure also means additional financial risk
(also known as bankruptcy risk). Therefore it is important to manage the
exposure to financial risk and the following ratios are useful in identifying
this risk.
Total Debt to
Total Assets
This is the first broadest test to measure the
proportion of total debt used in the capital structure to finance the assets.
The higher the ratio, the greater the financial risk. But this phenomena
is not always true, because the asset values used to calculate this ratio are
historical values, not at the current or fair market values. Moreover, it
also ignores future potential of the business and effectiveness of the assets.
However, it gives a general idea to the analyst regarding the amount of debt,
and whether further investigation is needed to explore reasons for abnormality
in the ratio. The ratio is computed using the following formula:
=
Total Debt
Total Assets
Debt to
Equity
This is the ratio of
total debt, both current and long-term, and stock holder’s equity (net assets).
This ratio analyzes the relative proportion of all debt claims to ownership
claims against total assets, and is used as a barometer of debt exposure.
=
Total Debt
Shareholders’ Equity
This ratio carries
the same limitation as other debt ratios, as all the amounts are derived from
the balance sheet which does not represent current fair market value nor the
impact of operational performance.
Debt to
Capitalization
This is more refined
version of total debt to total assets ratio, involving only long-term portion of
debt in invested capital. Invested capital is the sum of long-term debt (LTD)
and stockholders’ equity.
=
Total Long Term Debt
Total LTD + Equity
This ratio is
important in obtaining additional financing, as usually debt covenants from
existing creditors provides certain limits to maintain this ratio. This ratio
also has the same limitations as other debt ratios.
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