Key Financial Ratios – Solvency / Financial Leverage

Key Financial Ratios – Solvency / Financial Leverage

There are a number of key financial ratios that can be used to assess a firm’s performance, competitiveness and ability borrow and pay debt. These key financial ratios cover a broad range of performance indicators including: (1) Profitability, (2) Asset Productivity, (3) Liquidity, (4) Solvency / Financial Leverage and (5) Market Value. This tutorial is the fourth of 5 on key financial ratios. Solvency / Financial Leverage is covered in this one. 

 

Utilizing these ratios requires the financial statements of the firm you’re looking to assess. It is highly recommended that this exercise be done for the firm’s competitors within the industry as well so that a relative comparison can be made since there are no universal thresholds for an “optimal” ratio.

Key Financial Ratios :  SOLVENCY / FINANCIAL LEVERAGE

1. Total Debt Ratio
Definition : Measures how much of a firm’s assets are leveraged (financed with debt)
Notes: It is difficult to come to a conclusion on leverage based on one firm’s measure alone. Industry comparison provides a better picture of the company’s leverage position
Financial Statement(s) Needed : Balance Sheet
Formula: Debt Ratio = Total Liabilities / Total Assets
Example :
Current Assets = $400; Property, Plant & Equipment = $1,000; Intangible Assets = $100; Total Assets = $1,500
Current Liabilities = $250; Long-Term Liabilities = $500; Total Liabilities = $750
Total Debt Ratio = $750 / $1,500 = 50%
Other Notes: Easy to influence year end ratio by a firm by waiting towards the end of the fiscal year to pay off some debt.

 

2. Long Term Debt Ratio
Definition : Measures how much of a firm’s assets are leveraged with long-term debt.
Notes: It is difficult to come to a conclusion on long term leverage based on one firm’s measure alone. Industry comparison provides a better picture of the company’s leverage position
Financial Statement(s) Needed : Balance Sheet
Formula: Long Term Debt Ratio = Long Term Liabilities / Total Assets
Example :
Current Assets = $400; Property, Plant & Equipment = $1,000; Intangible Assets = $100; Total Assets = $1,500
Current Liabilities = $250; Long-Term Liabilities = $500; Total Liabilities = $750
Total Debt Ratio = $500 / $1,500 = 33%
Other Notes: May want to tweak the denominator to represent only those assets that are actually financed with long term debt. Also take in to consideration accumulated depreciation, which reduces the asset value as it is represented in the balance sheet.

 

3. Debt / Equity Ratio
Definition : Measures the capitalization / capital structure of a firm by way of comparing the two ways a company is financed
Notes: The lower the number, the less debt being carried by the company and vice versa.
Financial Statement(s) Needed : Balance Sheet
Formula: Debt / Equity Ratio = Total Liabilities / Total Shareholders’ Equity
Example :
Current Assets = $400; Property, Plant & Equipment = $1,000; Intangible Assets = $100; Total Assets = $1,500
Current Liabilities = $250; Long-Term Liabilities = $500; Total Liabilities = $750; Since Total Assets must equal Total Liabilities + Shareholders Equity, the Total Equity in this case must be $750
Total Debt Ratio = $750 / $750 = 1 (meaning half of the capitalization is debt)
Other Notes: Remember, the lower the number, the less debt the company is carrying. So a 0.5 would mean that the company is carrying half as much debt as equity.
4. Times Interest Earned Ratio (TIE)
Definition : Measures how many times interest can be paid with net income
Notes: From a creditor’s perspective, the higher this number is, the more confident they will be about lending money to the firm
Financial Statement(s) Needed : Income Statement
Formula: Times Interest Earned = Earnings Before Interest & Taxes (EBIT) / Interest Expense** EBIT = Net Income + Tax Expense + Interest Expense
Example :
Interest Expense = $100; Tax Expense = $50; Net Income = $200
Times Interest Earned = ($200 + $50 + $100) / $100 = $350/$100 = 3.5x
Other Notes: Remember that Net Income (GAAP) is based on accrual accounting and not necessarily cash accounting. It’s possible for a positive Net Income to be without cash.

 

Read About Other Key Financial Ratios:

Key Financial Ratios – Profitability

Key Financial Ratios – Asset Productivity

Key Financial Ratios – Liquidity

Key Financial Ratios – Market Value

Submit a Comment

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>