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What Are Leverage Ratios?

- Wednesday, September 28, 2016

Do you wonder why banks or investors like to calculate ratios and look at historical financial information?

Well, it helps tell a story about your company.  Now, it’s not the whole story, but gives a reader of the financial statements, insight into what has happened in the company.  They must be looked at in relationship with the leadership, management, industry and market conditions.

Let’s take a closer look at the Leverage Ratio.

Leveraging means borrowing money to invest into the company. The expectation is the profits of the business will be sufficient to support and pay back the amount borrowed.

The leverage ratios give insight into a company's debt balances and capacity to meet its financial obligation. These include debt to equity; debt to assets; and interest coverage.

Debt to Equity

This is the most commonly used leverage ratio and is calculated: Liabilities / Shareholders’ Equity.  This measures the amount of debt a company has taken on to manage their growth.  There are differing opinions on an ideal ratio, but for me, less than a one is great (for every dollar of debt, there is two dollars of equity).

Debt to Assets

This ratio assesses what portion of a company’s assets is financed through debt, and is calculated: Total Debt / Total Assets.  The lower the result the fewer assets were purchased by debt.  If the ratio calculates at .25, it means the company used cash (from operations or raised capital) to pay for the assets on the books.

Interest Coverage

A company’s ability to cover the interest expense on its debt is measured by this ratio.  The formula is: Earnings Before Interest and Taxes (EBIT) / Interest Expense.  The higher the result the stronger the company’s ability to meet it’s obligation.

Understanding these ratios in your business is important; knowing how to strategically manage them can be vital to your ongoing growth.

Live Passionately!

John

561.302.6304

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Barbar Financial Solutions provides peace of mind to CEOs of small to mid-sized companies.  Our team provides a clear financial picture of the business, and then implements strategies to help our clients grow their profits and cash flow.


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