Leverage Ratio

Leverage Ratios allow a quick analysis of a Company’s ability to service Debt. The Ratios use items for the three Financial Statements and focus on the Capital Structure and the ability to service Debt.

Let’s cut to the chase and discuss why it is critical to understand the Debt obligations of a Company. In Bankruptcy when a Company fails to meet its Debt Servicing obligations. Debt is Senior to Equity. Understand if your Equity investment is at risk, to understand this, it is key is to be fluent in the use of the various Leverage Ratios which are Financial Ratios, as opposed to Valuation Ratios. The Leverage Ratios are calculated using items from across the three Financial Statements, Balance Sheet, Profit and Loss and Cash Flow Statement. They are a set of ratios focusing on a Company’s Capital Structure and a Company’s Debt Servicing.

Let’s do some quick calculations on two commonly used Leverage Ratios.

Capital Structure: The Net Debt-to-Equity Ratio, the formula is:
Net Debt-to-Equity = (Total Debt – Cash and Equivalents) / Equity.
Equity = $100 million, Net Debt = $130 million

Company’s Debt Servicing: The Interest Coverage Ratio, the formula is: interest Coverage Ratio = EBITDA / Interest Expense.
EBITDA = $40 million, Interest Expense = $8 million

Do you ever wonder why Banks trade at a PE Ratio discounted to the broad Stock Market? Banks have Regulatory Oversight of their Capital Structure. Keep in mind Banks are just highly leveraged Companies.