There are few companies that boast of their excellent financial health i.e. they are debt free. However, most of the companies at one point or another, try to secure funding to purchase equipment, launch new products, expand their business and so on. It is extremely important that the businesses must try to maintain a good financial record so investors can determine if the investments in the company would be risky or worthwhile. One of the metrics that can be used to ascertain the financial health of a company is the leverage ratio. So, what exactly is a leverage ratio and how it is important for investors? Let’s try to find out the answers.
What is Leverage Ratio?
A leverage ratio is essentially a financial measurement, which is used to determine the long-term solvency of a company. In simple terms, it means ascertaining debt levels of the company. If a company has higher debt on its balance sheet, then the investors may not be keen enough to invest. Higher debt levels are considered to be extremely risky for an organization and its investors.
Importance of Leverage Ratio
Knowing about the leverage ratio is imperative both for the company and investors. It helps the company to determine the total amount they can actually borrow to increase their profitability levels. On the other hand, through the ratio, the investors can assess whether it will be beneficial or riskier to invest in the company’s shares.
If the debt levels of a company are on the higher side, then it clearly indicates that the company is utilizing the debt for running its business operations. On the other hand, a company with the lower ratio or debt levels specifies that even if the company has debt, it is generating enough revenue to finance its assets or run business operations through profits.
Types of Leverage Ratio and Their Calculation
There are prominent types of leverage ratios that give an excellent account of the debt levels or financial health of the company. These are as follows:
It is used to calculate the total debt or liabilities by the total value shareholder’s equity. It basically indicates the total capital or debt provided by the creditors and shareholders of the company. Through this, the investors can determine whether the company has the ability to repay its creditors on time or not.
D/E Ratio = Total Debt / Total Equity
If you are planning to invest in the stock market, then go for those companies having lower Debt-Equity (D/E) Ratio or decreasing consistently.
For example, the balance of a Company ABC as on 31 March 2018 shows Rs 3,00,000 of total debt and Rs 5,00,000 of equity.
Hence, the debt to equity ratio would be = 3, 00,000 / 5, 00,000 =0.6
A debt ratio of an organization is total debt divided by its total assets. It is calculated by:
Debt Ratio = Total Debt / Total Assets
For example, the balance sheet of a Company ABC indicates Rs 2, 00,000 of debt and Rs 5, 00,000 of assets, hence the debt ratio will be:
Debt ratio = 2, 00,000 / 5, 00,000
Interest Coverage Ratio (ICR)
Through this ratio, whether a company is able to pay the interest on debts easily or not. Here the short-term financial situation of the company is analyzed. A company with an excellent interest coverage ratio is considered best for making an investment. It is calculated by:
Interest Coverage Ratio = Earnings before Interest and Taxes (EBIT) / Interest Expense
For example, the EBIT of a Company ABC is Rs 30, 00,000 and its interest expense is Rs 10, 00,000, then the ICR would be:
30, 00,000/ 10, 00,000 = 3
Can you imagine, if there is no news about the financial position of the company, then how can you take an investment decision? This is why keeping a tab on the leverage ratio of a company is quite important. This is because when it comes to the investors, then they always show a positive interest to buy the shares of the companies with low leverage ratios. They always focus on two things i.e. getting a good Return on Investment (ROI) and safeguarding their interests, so even if a business suffers heavy loss or goes bankrupt, then their money is not lost.