Understanding Leverage and Debt Ratios for Business Solvency, Study notes of Financial Statement Analysis

Download Understanding Leverage and Debt Ratios for Business Solvency and more Study notes Financial Statement Analysis in PDF only on Docsity! Lesson-36 LEVERAGE/DEBT RATIOS (b) Analysis by long-term creditors: Interest of long-term creditors is to see the long-term solvency of the business and rate of return on their loans. Solvency is the ability to meet outside liabilities from total assets. Indicators of solvency are the Long-term Solvency, which are as follows:- i) Debt –To-Total-Assets: The debt-to-total assets ratio is derived by dividing a firm’s total debt by its total assets: It indicates percentage of total assets financed by debt = Total outside liabilities /Debt = 75 = 37.5% Total assets (total liabilities +shareholders funds) 200 From creditors’ point of view, the lower the debt ratio, the better it is because it means that shareholders have contributed the bulk of funds and margin of protection to creditors is high. In addition to the previous ratio, we may wish to compute the following ratio, which deals with only the long-term capitalization of the firm: *Long Term debt/ Total Capitalization (Share capital + Fixed Liabilities) Where total capitalization represents all long-term debt and shareholder’s equity. This tells us the relative importance of long term debt to the capital structure (long-term financing) of the firm. Leverage: It means operating a business with borrowed money. It should be used to earn a return (on assets or equity) greater than cost of borrowing i.e. interest. Alternate term for this is “Gearing”. ii) Equity ratio: Total stockholders equity (including preferred stock) = 125 = 62.5% Total assets (total liabilities + shareholders funds) 200 This is opposite of Debt ratio. Low equity ratio indicates extensive use of leverage i.e. borrowings. iii) Debt-To- Equity: Ratio of borrowed capital to Shareholders’ funds is called Debt – Equity Ratio. The debt-to-equity ratio is computed by simply dividing the total debt of the firm (including current liabilities) by its shareholders’ equity: = 75 = 0.6 i.e. Debt is 0.6 of Equity =Debt Ratio = 37.5: 62.5 (Debt equity Ratio) 125 Equity Ratio Creditors would generally like this ratio to be low. The lower the ratio, the higher the level of firm’s that is being provided by shareholders and the larger the creditor cushion (margin of protection) in the event of shrinking asset values or outright losses. Depending on the purpose for which the ratio is used, preferred stock is sometimes included as debt rather than as equity when debt ratios are calculated. Preferred stock represents a prior claim from the stand point of the investors in common stock: consequently, investors might include preferred stock as debt when analyzing a firm. The ratio of debt to equity will vary according to the nature of the business and the variability of cash flows. A comparison of the debt to equity ratio for a given company with those of similar firms gives us a general indication of the credit worthiness and financial risk of the firm. docsity.com