Using the Leverage Ratio to Uncover DebtCalculating the Leverage Ratio
The higher the ratio, the higher the debt. Generally, ratios of higher than 15 are a warning signal. Low ratios may indicate underutilized assets. In the days of Enron, some company heads became experts at hiding debt levels. Though Enron formed entire companies to move debt, more often companies hide liabilities on the balance sheet from the
debt equity ratio.
The ratio finds all debt by utilizing the accounting equation:
The company either owns an asset (Assets = Owner's Equity) or financed part or all of it (Assets - Liabilities = Owner's Equity). A ratio of one equals no debt. For example, if the owner invested $50,000 to start a business in cash, the ratio = 1.
If the company then purchases machinery for $500,000 on loan, the ratio becomes 11.
In the example above, the business owns $50,000 of the total assets of $550,000, so total debt must equal 500,000. To add relevance to this number, compare the ratio with competitors and industry averages. For example, capital-intensive industries like auto manufacturers have much higher ratios, while the software industry, which requires much less capital investment, has lower debt ratios.
Sunny Sunglasses has almost 50% less assets from debt than the industry average, and 30% less assets from debt than its closest competitor. Though the ratio signals low debt in our example, it may also indicate that Sunny Sunglasses has not fully utilized its assets to earn a profit as well as the industry or its competitors. If, for example, a business can borrow money at 6% to acquire assets that return 12%, borrowing funds for additional assets increases the net income and value of the business. The company should earn enough on the investment to pay the debt charges and make a profit. The interest coverage ratio can determine whether or not the company is earning enough to cover interest expenses. Back from the leverage ratio to the financial ratios main page Back to the accounting terms main page Back to the GAAP small business accounting home page
|
