FR - Leverage Ratios

Written by Administrator

Monday, 23 June 2008 13:45

Ratios are a way to evaluate the performance of your business and identify potential problems. Each ratio informs you about factors such as the earning power, solvency, efficiency, and debt load of your business. They are used to measure the relationship between 2 or more components of the financial statements and have greater meaning when the results are compared to industrial standard for businesses of similar size and activity. Leverage ratios: examine how assets of the business are financed · Debt-to-asset ratio · Debt-to-equity ratio Debt-to-asset ratio Calculation: liabilities / assets Also known as Debt Asset Ratio, it measures the extent to which the acquisition of assets has been financed by creditors. Example: Debt-to-asset ratio : 140.02 % This result may be considered positive or negative, depending on the industry standard for companies of similar size and activity. For creditors, a lower Debt-to-Asset Ratio is preferred as it means shareholders have contributed a large portion of the funds to the business, and thus creditors are more likely to be paid Debt-to-equity ratio Calculation: total liabilities / shareholders' equity Measures management's reliance on creditor financing as well as the business's indebtedness compared to the amount invested by its owners. This ratio indicates the amount of liabilities the business has for every dollar of shareholders' equity. Because this ratio is a good indicator of a business's capacity to repay its creditors, it is considered very important by most term lenders Example: Debt-to-equity ratio : 3.50 The Debt-to-Equity proportions are decided by management and thus there is no "ideal" ratio value. The reliance on creditor financing needs to be analyzed in light of other factors such as: the historical trend of this ratio for the business, industry standards for companies of similar size and activity, and whether the company is in the start-up or established phase. Term lenders prefer a lower debt-to-equity ratio as it indicates a lower reliance on creditors and therefore a greater capacity for the business to repay its creditors