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Accounting Ratios -Leverage Ratios

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The leverage ratio is a type of financial ratio which indicates the level of debt and measure a company ability to pay off its obligations. The ratios provide an indication of how the company’s assets and business operations are financed using debt and equity. The debt ratio, debt to equity ratio, and equity multiplier are the most common leverage ratio.

The ratio of debt and equity ratio in the company capital is the most basic indicator of the company’s long term financial situation. Companies must maintain a good balance between debt and equity in its capital structure taking the advantage of tax benefits but also, considering the financial risk that may increase in the level of the debt obligation. 

The most used formula for leverage ratios are shown in table below:

Ratios    Debt ratio            Debt to equity ratios      Financial leverage ratio

                Debt to assets or gearing ratio                  Equity multiplier(EM)

Formula               Total debt / Total Assets               Total debt / Total Assets               Total Assets / Total Equity

Purpose               Calculating total debt as a proportion of total assets        Calculates dollars of debt per dollar of equity                Financial leverage is key input in the DuPont decomposition of return on equity. 

Debt ratio is also common leverage ratio, the debt ratio is calculated by dividing the sum of short-term debt and long term debt by the total assets.

Debt to equity ratio and financial leverage ratio is similar but different in many ways. The financial leverage ratio (also called equity multiplier) has its own significance in that it is the capital structure component used in decomposing return on equity in the DuPont Analysis.

ROE = Net profit Margin * Total Asset Turnover * Financial leverage ratio

The leverage ratio can be converted using the following equation assuming total debt equals total liabilities:

Debt Ratio = (1+D/E Ratio)/D/E Ratio = EM-1/EM

The important indicator of a company’s financial and business risk are the degree of operating leverage and degree of financial leverage

Example

Extract from keta balance sheet at the end of the financial year 2019, calculate the debt ratio for the company and then convert it to debt-to-equity ratio and financial ratio:

USD in Million    2019

Total assets        76,962

Current liabilities             

Short-term debt               11,031

Accounts payable            6,487

Accrued liabilities             5,779

Deferred revenues         1,193

Other current liabilities  2,441

Total current liabilities    26,931

Non-current liabilities   

Long-term debt                23,847

Capital leases    

Pensions and other benefits       8,365

Minority interest              69

Other long-term liabilities            3,984

Total non-current liabilities          36,265

Total liabilities    63,196

Stockholders’ equity     

Common stock  5,593

Retained earnings           26,301

Treasury stock   (17,005)

Accumulated other comprehensive income        (1,192)

Total stockholders’ equity            13,697

Total liabilities and stockholders’ equity 76,893

The debit equals the sum of interest-bearing short term and long term debt plus any other liabilities of debt like leases, pensions, etc. The Keto company total debt is $43,243 million (= $11,031 million-plus $23,847 million-plus $8,365 million Total assets are $76,962 million which result debt ratio of 0.56 ($43,243 million divided by $76,962 million).

Debt $43,243 million and total shareholders’ equity is $13,697 which indicates that the debt to equity ratio is 3.16 (=$43,243 million divided by $13,697 million).

Financial leverage ratio equals total assets (i.e. $76,893 million) divided by total equity (i.e. $13,697) which is 5.6.

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