Leverage Ratio 4 types of ratios and how to calculate with formula

  1. Fundamental Analysis
    1. fundamental analysis Tools and Skills for smart Investing
    2. What is compound interest in investment with examples
    3. Long term investment Tips for qualitative and quantitative analysis
    4. “Annual Report Explained Understanding Company Financials and Insights “
    5. Financial Statements Guide to Understanding Profit and Loss, Balance Sheets, and Cash Flow
    6. Understanding financial statements from two different angles
    7. Profit and Loss Statement How to understand Revenue Figures and Other Key Metrics for smart Investment Decisions
    8. Understanding Profit and Loss Statement Statement Profit before tax Net Profit after tax with examples
    9. Balance Sheet Definition and Examples
    10. liability Understanding 3 types of liabilities with examples
    11. Asset Understanding types of Assets in Balance Sheet
    12. Cash Flow Statement How to Read and Understand with examples
    13. Everything about Cash Flow Statement and Financial Statement
    14. Financial Ratio An analysis of the 4 types of ratios
    15. EBITDA understanding margin formula with examples
    16. Leverage Ratio 4 types of ratios and how to calculate with formula
    17. “Operating Ratio 7 types of ratios and how to calculate with the formula and examples “
    18. 3 valuation ratios Price to Sales (P/S), Price to Book Value (P/BV) and Price to Earnings (P/E) analysis with formula
    19. How to Pick a Share Basic Best Practices for New Investors with checklist
    20. Equity Research Guide to Evaluating Share Investment Potential with checklist
    21. Discounted Cash Flow technique The Key to Evaluating Share Prices and Maximizing Investment Returns
    22. DCF Analysis A Step-by-Step Guide to Valuing Shares like a Pro with examples
    23. NPV Net Present Value What does it mean with examples
    24. When to Sell a Share A Guide to Maximizing Profits and Protecting Your Portfolio
    25. Current Assets and Noncurrent Assets: What id the Difference with examples
    26. Return on Equity ROE What It Means and How to Calculate
    27. ROE, ROA, and ROCE How to calculate with examples
    28. asset turnover ratio Definition and Understanding the Impact
    29. Inventory Turnover Ratio What It Is, How It Works and how to calculate
    30. pe ratio Understanding Price Earning Ratio to Assess a Shares
    31. economic moat Advantage  in business
    32. Equity Research Step-by-Step Checklist for Analysing Company Performance
    33. Financial Health – Definition, Determinants, How to calculate
    34. Time Value of Money Understanding and Calculating Future and Present Value
    35. Sell Shares: Factors to Consider for Profit Booking
Marketopedia / Fundamental Analysis / Leverage Ratio 4 types of ratios and how to calculate with formula

Organisations which are proficiently controlled recognise that debt can be beneficial in situations where the funds are being invested into a venture that will yield rewards higher than the amount paid for interest. Financial advisors would advise using debt sensibly in order to maximise returns on equity.

If a company accumulates too much debt, the interest charges can reduce its shareholders’ profits. It is essential to be aware of the difference between good and bad debt, and leverage ratios are an effective method of assessing a company’s financial reliance on borrowing.

We will analyse these leverage ratios: quick ratio, current ratio, debt-to-equity, and interest coverage.

  1. Interest Coverage Ratio
  2. Debt to Equity Ratio
  3. Debt to Asset Ratio
  4. Financial Leverage Ratio

We have been looking at Amara Raja Batteries Limited (ARBL) to get a grasp of leverage ratios. However, let’s take a closer look at a company with substantial debt on its balance sheet. Jain Irrigation Systems Limited (JISL) is an excellent example of this. You can have your practice, too, by calculating the ratios for a company of your choice.

Interest Coverage Ratio:

The interest coverage ratio, sometimes called the debt service ratio or debt service coverage ratio, is an indicator of a company’s financial health. It allows us to assess how much money the company is making against its interest payments. For instance, if its liabilities stand at Rs.100 whilst income is Rs.400, there is enough capital to cover financing obligations. However, if this relation is reversed and the ratio is too low, then it could indicate a high risk of bankruptcy or default on payments.

Here’s how you can calculate the interest coverage ratio: 

Earnings before Interest and Tax are divided by Interest Payment

The ‘Earnings before Interest and Tax’ (EBIT) can be calculated as follows:

EBITDA – Depreciation & Amortisation

We can use this ratio to analyse Jain Irrigation Limited. Here is their Profit and Loss statement for FY 14, with Finance costs highlighted in red:

We know that revenue – expense = EBITDA

To calculate expenses, we deduct Finance costs (Rs.467.64Crs) and Depreciation & Amortisation expenses (Rs.204.54) from Rs.5730.34 Crs, the total expenses.

Therefore EBITDA = Rs.5828.13 – 5058.15 Crs

EBITDA = Rs. 769.98 Crs

As we already know, EBIT is equal to EBITDA – [Depreciation & Amortisation]

= Rs.769.98 – 204.54

= Rs. 565.44

We know Finance Cost = Rs.467.64,

Hence Interest coverage is:

= 565.44/ 467.64

= 1.209x

The ‘x’ in the preceding figure signifies a multiple; therefore, 1.209x should be read as 1.209 ‘multiplied by’.

The interest coverage ratio of 1.209x implies that Jain Irrigation Limited is generating an EBIT of 1.209 times for each Rupee of the interest payment obligation.

Debt to Equity Ratio:

This ratio is straightforward to calculate; both variables needed can be found in the Balance Sheet. It’s a measure of the total debt capital in relation to the total equity capital. A value of 1 signals an equal amount of debt and equity capital, whilst higher debt to equity (greater than 1) shows increased leverage, so one should tread cautiously. 

Results below 1 indicate a higher proportion of equity capital in comparison to debt.

Here’s how we can calculate Debt to Equity ratio: 

[Total Debt/Total Equity]

Please remember that this total debt encompasses both short- and long-term liabilities.

This Balance Sheet for JSIL features total equity, long and short-term debt, with the relevant information being highlighted.

Total debt = Long term borrowings + Short term borrowings

= 1497.663 + 2188.915

= Rs.3686.578Crs

Total Equity is Rs.2175.549 Crs

Thus, here’s how Debt to Equity ratio will be calculated:

= 3686.578 / 2175.549

= 1.69

Debt to Asset Ratio:

This ratio offers insight into the way a company has chosen to finance its assets. It shows the fraction of assets that are financed by debt.

The equation to calculate it is:

Total Debt / Total Assets

Based on the Balance Sheet, we have the information that JSIL’s total debt amounts to Rs.3686.578 Crs, while the total assets are recorded as Rs.8204.447 Crs.

Debt to Asset ratio is:

=3686.578 / 8204.44

= 0.449 or ~45%.

Roughly 45% of JSIL’s assets are financed by debt capital and creditors, meaning the owners only have to account for the remaining 55%. This higher number of debt-funded assets may cause an investor concern as it suggests a larger level of leverage and risk.

Financial Leverage Ratio

In the preceding chapter, we examined the financial leverage ratio in connection with the return on equity. This provides valuable insights into the extent to which equity is employed to finance assets.

The formula for computing the financial leverage ratio is:

The leverage ratio, also known as the financial leverage ratio, is calculated by dividing the average total assets by the average total equity. 

Upon examining JSIL’s balance sheet for FY14, it is evident that the average total assets amount to Rs.8012.615, while the average total equity is Rs.2171.755. This ratio provides insight into the company’s financial leverage.

8012.615 / 2171.755

= 3.68

JSIL holds Rs.3.68 worth of assets for each unit of equity, so its leverage is high.

    captcha