Leverage ratios are a powerful way to analyze a company's financial health. be aware of the risks associated with high ratios.
Every company has financial obligations of some sort, and organizations often borrow money in the form of debt to fulfill these obligations. The balance between a company's borrowed debt and accumulated equity can tell you a lot about how that company is doing. This is where leverage ratios come in.
This article will explore:
Leverage ratios compare the proportion of debt to the proportion of equity within a company.
An individual may use a leverage ratio to determine the makeup of a company's capital structure and consequently form conclusions about its financial health. Namely, they may use leverage ratios to determine the debt-to-equity ratio of a company.
Several financial leverage ratios can be considered quite common: these include debt-to-capital ratio, debt-to-equity ratio, and EBITDA ratios. These various types of leverage ratios are explained in depth below.
The leverage ratio of a given company can reveal how much of its finances must be paid back to lenders and how much of its total assets the company actually owns.
Typically, the higher these ratios are, the more debt they use to finance their operations as an institution. This means that two companies with similar net worths may have entirely different debt-to-equity or debt-to-capital ratios depending on how much of their net income is derived from accounts payable or debt.
EBITDA ratios analyze a given company's ability to pay off its debt. Credit agencies develop these ratios to determine how long it would take an organization to eliminate its incurred debt.
The term EBITDA is an acronym for a larger equation that can be manipulated to derive this sentiment. The acronym stands for: Earnings Before Interest, Taxes, Depreciation, and Amortization.
Leverage ratios, as stated above, are primarily utilized for analysis regarding a company's total assets. Two companies with the same net worth may derive their capital gains from entirely different places, and leverage ratios attempt to underline that distinction.
Banks use leverage ratios to determine the viability of a company's finances. When a company goes to a bank to request a loan, it will be audited for several reasons:
A company's debt may also deter investors from investing in it and steer them towards direct competitors. Suppose an investor decides between two similar companies and sees that one company has higher debt ratios. In that case, they may be more apt to choose the other organization.
However, using debt to leverage a financial situation is not inherently harmful. A company's ability to earn large loans may demonstrate strength in the product or integrity they've achieved with the bank that gave them the loan. In other words, seeing a company leverage its value with debt may lead you to believe their future is bright enough to earn the trust of the bank that entrusted that loan to them.
There are several reasons why investors would be interested in knowing a company's leverage ratio:
Typically, higher leverage ratios are associated with a higher proportion of debt to equity and vice versa for low leverage ratios.
As detailed above, leverage ratios can be significant for many reasons:
To understand this concept in further detail, let's look at an example.
Jeffery is a retail investor who is interested in buying shares of stock in a tech company. After lots of research, he discovers two companies developing a new CRM software that will automate significant marketing decisions for business owners.
Jeffery is excited about the software but torn between which of the two companies will produce more profitability. In hopes of deciphering which firm will yield a higher return on investment, Jeffery takes a closer look at each company's financial statements.
High leverage situations can be interpreted as inherently high risk because they are driven by debt.
Suppose a company begins to collect debt...
In this case, they start to rely on liabilities which grow increasingly as interest rates take effect. Therefore, a company with no leverage may perform better than their counterpart with lots of debt because they do not have to pay off lenders and can instead keep their profit/distribute it out to shareholders in the form of dividends.
A company's retained earnings are defined by the money they keep once all their expenses and dividends are paid. A company may accumulate debt to purchase assets like technology and other supplies. Still, they may eventually have to pay elevated prices for it down the road. Therefore, as explained in the example above, it can be more favorable to obtain the same net worth as your competitor with lower amounts of leverage.
So, how does a company balance leverage?
There must be an equilibrium point in which leverage is minimized and production is maximized from the firm's perspective. This optimal point of return mitigates the use of debt in corporate debt. It, therefore, minimizes debt for shareholders and investors as well.
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