Financial Leverage Ratios - Essay Example

Financial Leverage [N a m e] INTRODUCTION This report presents the analysis of financial leverage ratios that are used to gauge the extent to which a firm finances its operations with borrowed money rather than with owners’ equity. Analysis of a firm’s financial leverage ratios is essential to evaluate its long-term risk and return prospects. Analysis of a firm’s financial leverage ratios is essential because financial leverage ratios accomplish two things: First, they are a measure of the extent to which firms finance their assets through debt; second, they are the indicators of the financial risk of the firm (Arditti, 19). Higher expected returns are associated with the firms that are having high financial leverage ratios when the economy of a country is normal. Whereas, when the economy of a country is in recession so firms having high financial leverage ratios will face risk of loss. On the other hand, firms having low financial leverage ratios are supposed to be less risky but higher expected returns are not associated with these firms. IMPORTANCE OR AIM OF THE STUDY The importance or aim of this study is to show that analysts use financial leverage ratios to accomplish two things: First, they are a measure of the extent to which firms finance their assets through debt. Second, they are the indicators of the financial risk of the firm. Analysis of a firm’s financial leverage ratios is essential to evaluate its long-term risk and return prospects. Leverage as a debt-financing indicator is important because whenever a firm’s rate of return on assets is in access of interest rate, the profits to equity investors are magnified in direct proportions to increases in leverage. The reverse also holds true-whenever the rate of return falls below the interest rate, the profits to investors decline with increases in leverage. In fact, if the firm is sufficiently levered, interest expenses may be so high that under adverse economic conditions the firm may not be capable of paying them-that is, financial risk is directly proportional to leverage. FINANCIAL LEVERAGE RATIOS: Financial leverage ratios are also called as Debt ratios or long-term solvency ratios. These are the ratios that are used to: Measure the firm’s ability to meet its long-term financial obligations like final principal and interest payments on its borrowings and other financial obligations. Measure a firm’s propensity to utilize debt in financing its assets as well as its financial risk. Measure the financial health of a firm. Measure the long-term and short-term solvency position of a firm. In order to keep financial risk at acceptable level, companies need manage their debt ratios carefully. Moreover managing these ratios is also important when companies are seeking loans and favorable debt ratios help them in negotiating a favorable interest rate. In isolation, financial leverage ratios are of no use. So a firm should go for trend and industry analysis to determine how well it is managing its debt position (Kim, , Lewellen and McConnell, 86) FINANCIAL LEVERAGE RATIOS: Financial leverage ratios consist of the following important ratios: Debt ratio Equity Ratio Debt-to-equity Ratio Interest coverage ratio Fixed charge coverage ratio Financial leverage Capitalization ratio Asset coverage ratio 1. DEFINITION OF DEBT RATIO: Debt ratio is the ratio that measures the claim of creditors on total assets. It also indicates the amount invested by the creditors in total assets of the firm. It shows how much assets were funded through creditors long and short-terms or total claims of creditors on assets (Malitz, and Long, 327) Low debt ratios are preferred by creditors because the lower the ratio, the greater the protection against creditors’ losses in case of business decline. On the other hand, Leverage magnifies profits so stockholders can benefit from it. FORMULA FOR DEBT RATIO: Formula for debt ratio can be given as, Debt Ratio = Total debt/Total assets Where, Total debt includes both current liabilities and long-term debt. 2. DEFINITION OF EQUITY RATIO: One indicator of the amount of leverage used by a business is the equity ratio. This ratio determines the amount of a firm’s total assets that are financed by Shareholders’ equity. A low equity ratio indicates an extensive use of leverage, that is, a proportion of financing provided by creditors, a high equity ratio, on the other hand, indicates that the business is making little use of leverage. From the viewpoint of the common stockholder, a low equity ratio will produce maximum benefits if the management is able to earn a rate of return on assets greater than the rate of interest paid to creditors. However, a low equity ratio can be very unfavorable if the return on assets falls below the rate of interest paid to the creditors. FORMULA FOR EQUITY RATIO: The formula for equity ratio can be given as, Equity Ratio = Total Shareholders’ Equity/Total assets IMPORTANCE OF EQUITY RATIO: Equity ratio indicates the overall financial health of a firm. A firm having high equity ratio is supposed to have good solvency position whereas low equity ratio indicates an extensive use of leverage that is higher risk to creditors. 3. DEFINITION FOR DEBT-TO-EQUITY RATIO: Debt-to-equity ratio also called as “Gearing ratio” is used to measure: The extent to which a firm is reliant on its debt financing. Firm’s ability to repay its financial obligations. It measures the risk involved in the firm in financial terms. It also indicates the capital structure of the company. A company which has more than 50% long-term debts in its capital structure would be classified as a high gearing company and which may go into forceful liquidation if it fails to meet its liability on maturity (DeAngelo, and DeAngelo and Wruck, 2002). Contrary to this a low gearing company would be less risky. Low debt-to-equity ratios are preferred by investors and lenders because the lower the ratio, the greater the protection against investors’ or lenders’ losses in case of business decline. FORMULA FOR DEBT-TO-EQUITY RATIO: Formula for debt-to-equity ratio can be given as: Debt-to-equity ratio = Liabilities/Equity 4. DEFINITION OF INTEREST COVERAGE RATIO: Bondholders feel that their investments are relatively safe if the issuing company earns enough income to cover its annual interest obligations by a wide margin. A common measure of creditor’s safety is the ratio of operating income available for the payment of interest to the annual interest expense, called the interest coverage ratio (times interest earned ratio) (Michel, and Shaked, 92) It shows the operating profit covers interest in multiple time of interest. It also shows that the company can pay the cost of debt easily from its current earnings. FORMULA FOR INTEREST COVERAGE RATIO: Formula for interest coverage ratio is given as, Interest Coverage Ratio = EBIT/Interest expenses High interest coverage ratio shows the better financial health of a firm because a firm with high times interest earned ratio is able to meet its annual interest costs from operating income. Whereas, a firm with low times interest earned ratio is not able to meet its interest obligations and thus resulting in bankruptcy. 5. FIXED CHARGE COVERAGE RATO: The fixed charge coverage ratio is more comprehensive measure as compared to interest coverage ratio because it includes all fixed charges i.e. long-term leases and sinking fund payments. Leasing has become widespread in certain industries in recent years, making the fixed charge coverage ratio preferable to the interest coverage ratio for many purposes. Fixed charge coverage ratio is the ratio tat is used to measure the number of times fixed charges are covered by funds available from operations (Miller, 267). FORMULA FOR FIXED CHARGE COVERAGE RATIO: Formula for fixed charge coverage ratio can be given as, Fixed charge coverage ratio = EBIT + Lease payments/interest charge + Lease payments + {Sinking fund payments/ (1-tax rate)} 6. FINANCIAL LEVERAGE RATIO: The financial leverage ratio is a ratio that is used to measure the amount of firm’s total assets that are financed by the common equity capital. Benefits are associated with high financial leverage ratio that is it enhances ROE. But at the same time higher risks are also associated with high financial leverage ratio (Chand Bhandari, 521). FORMULA FOR FINANCIAL LEVERAGE RATIO: Formula for financial leverage ratio can be given as, Financial leverage ratio = Total Assets/Common Equity Capital 7. DEFINITION OF CAPITALIZATION RATIO: Capitalization ratio is the ratio that is used to measure the amount of firm’s permanent capital funds that is from debt. Capitalization (capital structure) refers to a firm’s permanently committed capital funds. A Firm’s capital structure is equal to the sum of its long-term debt and stockholders’ equity (DeAngelo, and Masulis, 20). A firm with high capitalization ratio is supposed to be very risky because it fails to repay its debt obligations on time. Moreover, a firm having high capitalization ratio may be unable to get loans in future. On the other hand high capitalization ratio can be beneficial in a sense that it can increase ROI as there are tax advantages related with the borrowings. FORMULA FOR CAPITALIZATION RATIO: Formula for capitalization ratio can be given as, Capitalization ratio = long-term debt/capitalization Where, capitalization is equal to the sum of long-term debt and stockholders’ equity. 8. DEFINITION OF ASSET COVERAGE RATIO: It is the ratio that is used to measure a firm’s ability to cover its outstanding debts with its assets and it also tells the amount of assets that a firm is required to finance its debt obligations. The financial health of a firm is reflected by this ratio because it determines the total assets (excluding intangible assets) of the firm that are required to meet its debt obligations (Zingales, and Kaplan, 709) The book value of the assets is used by asset coverage ratio, which is a negative aspect of this ratio because the book value can differ from the asset’s actual liquidation value. So in this case misleading results will be given by this ratio. FORMULA FOR ASSET COVERAGE RATIO: Formula for asset Coverage ratio can be given as, Asset Coverage ratio = {(Total Assets - Intangible assets) – (Total Current Liabilities – Short-term debt)/ Total Amount of Debt CONCLUSION: In conclusion it can be said that analysis of a firm’s financial leverage ratios is essential to evaluate its long-term risk and return prospects. Leveraged firms accrue excess returns to their shareholders so long as the rate of return on the investments financed by debt is greater than the cost of debt. Financial leverage’s benefits are associated with additional risks in the form of loss. Moreover, the priority of interest and debt claims can have a severe negative impact on a firm when adversity strikes because it is not able to meet its interest obligations and thus resulting in bankruptcy. Higher expected returns are associated with the firms that are having high financial leverage ratios when the economy of a country is normal. Whereas when the economy of a country is in recession, firms having high financial leverage ratios will face risk of loss. On the other hand, firms having low financial leverage ratios are supposed to be less risky but higher expected returns are not associated with these firms. Works Cited Arditti, Fred D. “Risk and the Required Return on Equity.” The Journal of Finance 22.1 (Mar 1967): 19-36 Chand Bhandari, Laxmi. “Debt/Equity Ratio and Expected Common Stock Returns: Empirical Evidence.” The Journal of Finance 40.2 (Jun 1988): 507-528. DeAngelo, H, and R.Masulis. “Optimal capital structure under corporate and personal taxation.” Journal of Financial Economics 8 (1980): 3-29. DeAngelo, Harry, and Linda DeAngelo and Karen H. Wruck. “Asset liquidity, debt covenants, and managerial discretion in financial distress: the collapse of L.A. Gear” Journal of Financial Economics. April. 2002. 21 November 2011. Kim, E. Han, and Wilbur G. Lewellen and John J. McConnell. “Financial leverage clienteles: Theory and evidence.” Journal of Financial Economics 7.1 (March 1979): 83-109 Malitz, Ileen B, and Michael S. Long. “Investment Patterns and Financial Leverage.” Corporate Capital Structures in the United States (1985): 325 – 352. Michel, Allen, and Israel Shaked. “Multinational Corporations vs. Domestic Corporations: Financial Performance and Characteristics.” Journal of International Business Studies 17.3 (1986): 89-100 Miller, M. “Debt and taxes”. Journal of Finance 32 (1977): 261-75. Zingales, Luigi, and Steven N. Kaplan. “Investment-Cash Flow Sensitivities Are Not Valid Measures of Financing Constraints.” The Quarterly Journal of Economics 115.2 (2000): 707-712 Read More