LEVERAGE RATIO:

The short-term creditors, like bankers and suppliers of raw material, are more
concerned with the firm’s current debt-paying ability. On the other hand, long-term
creditors, like debenture holders, financial institution etc. or more concerned with the
firm’s long-term financial strengths. In fact, a firm should have a strong short-as well as
long-term financial position. To judge the long-term financial position if the firm,
financial leverage, or capital structure ratio are calculated. These ratio indicate mix of
funds provided by the owners and lenders. As a general rule, there should be an
appropriate mix of debt and owner’s equity in financing the firm’s assets.

The manner in which assets are financed has a number of implication. First ,
between debt and equity, debt is more risky from the firm’s point of view. The firm has a
legal obligation to pay interest to debt holders, irrespective of the profits made or losses
incurred by the firm. If the firm fails to pay to debt holders in time, they can take legal
action against it to get payment and in extreme cases, can force the firm into liquidation.
Secondly, use of debt is advantageous for share holders in two:
(a) they can retain control of the firm with a limited stake and
(b) their earning will be magnified, when the firm earns a rate on the total capital
employed higher than the interest rate on the borrowed funds. The process of magnifying
the shareholders’ return through the use of debt is called “financial leverage” or
“financial gearing” or “ trading on equity.”

However, leverage can work in opposite direction as well. If the cost of debt is
higher than the firm’s overall rate of return, the earning of shareholders will be reduced.
In addition, there is threat of insolvency. If the firm is actually liquidated for non-
payment of debt-holder’ dues, the worst suffers will be shareholders-the residual owners.
Thus, use of debt magnifies the shareholder’s earning as well as increases their risk.
third, a highly debt-burdened firm will find difficulty in rising funds from creditors and
owners in future. Creditors treat the owners’ equity as a margin of safety; if the equity
base is thin, the creditors risk will be high. Thus, leverage ratio are calculated to measure
the financial risk and the firm’s ability of using debt to shareholders’ advantage.

Leverage ratio may be calculated from the balanced sheet sheet items to
determine the proportion of debt in total financing. Many variation of these ratio indicate
the same thing-the extent to which the firm has relied on debt in financing assets.
Leverage ratio are also computed from the profit and items by determining the extent to
which operating profits are sufficient to cover the fixed charges.

TYPES OF LEVRAGE RATIO:

Debt Ratio:
several debt ratios may be used to analyse the long-term solvency of a firm. The
firm may be interest-bearing (also called funded debt) in the capital structure. It may,
therefore, computed debt ratio by dividing total debt (TD) by capital employed (CE) or
net assets (NA). Total debt will include short and long-term borrowings from financial
institution, debentures/bonds, deferred payments arrangement for buying capital
equipments, bank borrowings, public deposits and other interest-bearing loans. Capital
employed will include total debt and net worth (NW).

debt ratio = ____Total debut (TD)_________

Total debt (TD) + net worth (NW)

Note that capital employed (CE) equals net assets (NA) that consist of net fixed
assets (NFA) and net current assets (NCA). Net current assets are current assets (CA)
minus current liabilities (CL) excluding interest-bearing short-term debt for working
capital. These relationships are:

(NFA+CA) = (NW+TD+CL)
(NFA+CA-CL) = (NW+TD)
(NFA+NCA) = (NW+TD)
NA = CE

Because of the equality of capital employed and net assets debt ratio can be defined as
total debt divided by net assets

Debt ratio = _Total debut (TD)__

Net assets (NA)

Debt-Equity Ratio:

The relationship describing the lenders’ contribution for each rupee of the
owners’ contribution is called debt-equity ratio. Debt-equity (DE) ratio is directly
computed by dividing total debt by net worth:

Debt-Equity Ratio = __Total debt (TD)_

Net worth (NW)

Capital Employed To Net Worth Ratio:

There is yet another alternative way of expressing the basic relationship between
debt and equity. One may want to know: How much funds are being contributed together
by lender and owner for each rupee of the owners’ contribution? Caculating the ratio of
capital employed or net assets to net worth can find this out:

CE-to-NW ratio = _Capital employed (CE)__

Net worth (NW)
(OR)

NA-to-NW ratio = _Net assets (NA

Net worth (NW)
Other Debt Ratio:
Current liabilities (non-interest bearing currents obligations) are generally xcluded
from the computation of leverage ratios. One may like to include them on the ground that
they are important determinants if the firm’s financial risk since they represent
obligations and expert on the firm and restrict its activities. Thus, to assets the proportion
of total funds-short and long-terms- provided by outsiders to finance total assets, the
following ratio may be calculated:

TL-to-LF = _Total liabilities (TL)_

Total assets (TA)

In addition to debt ratio explained so far, a firm may wish to calculate leverage
ratio in terms of long-term capitalisation or funds (LTF) alone. Long-term funds or
capitalisation will include long-term debt and net worth. Thus, the firm may calculate the
following long-term debt ratos:

LT-toLF ratio = _ Long-term debt (LD)______

Long-term (LD) + Net Worth (NW)

What Do Debt Ratio Imply?

Whatever way the debt ratio is calculated, it shows the extent to which debt
financing as been used in the business. A high ratio means that claims of creditors are
greater than those of owners,. A high level of debt introduces inflexibility in the firm’s
operation due to the increasing interference and pressure from creditor. A high-debt
company is able to borrow funds on very restrictive terms to terms and conditions. The
loan agreements may require a firm to maintain current ratio, or restrict the payment of
dividend, or fix limits to the officer’s and employees’ salaries and so on. Heavy
indebtedness leads to creditors’ pressure and constraints on the management’s
independent functioning and energies. To meet their working capital need, the firm finds
difficulty in getting credit. It may have to borrow on highly unfavourable terms. Thus, it
gets entangled in a debt-trap.

A low debt-equity implies a greater claim of owners than creditors. From the
point of view of creditors, it represents a satisfactory since a high proportion of equity
provides a larger margin of safety for them. However, from the shareholders’ point of
view, there is a disadvantage during the period of good economic activities if the firm
employs a low amount of debt. The higher the debt-equity ratio, the larger the
shareholders’ earning when the cost of debt is less than the firm’s overall rate of returnon
investment. Thus, there is a need to strike a proper balance between the use of debt and
eequity.
Coverage Ratios:

Debt ratios described above are static in nature, and fail to indicate the firm’s
ability to meet interest obligations. The interest coverage ratio or the time-interest-
earned is used to test the test the firm’s debt-servicing capacity. The interest coverage
ratio is computed by dividing earnings before interest and taxes (EBIT) by interest
charges:

Interest coverage = _EBIT__

Interest

This ratio indicates the extent to which earning ma fall without any
embarrassment to the firm regarding the payment of the interest charges. A higher ratio is
desirable; but too high ratio indicates that the firm is very conservative in using debt, and
that it is not using credit to the advantage of shareholders. A lower ratio indicates
excessive use of debt, or the operating efficiency, or to retire debt to have a comfortable
coverage ratio.

The only limitation of the interest coverage ratio is that it does not consider
repayment of loans.