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Assessing A Company’s Gearing/Borrowing Or Leverage Level(Part1of5)

This article deals with the financial accounting ratio for assessing the LEVERAGE or gearing of a company Essentially, the Leverage Financial ratio should be able to measure the amounts of borrowed money being used by the firm.

Leverage Ratios are classified as either:

  • Capitalization Ratios, focusing on how investments are financed; or
  • Coverage Ratios, focusing on the ability to service the firm’s sources of financing.

Ratio DEBT / LEVERAGE / GEARING RATIO
Formula Total Liabilities
Total Assets
Use Measures the proportion of total assets financed by debt.
Values Lower is safer
Interpretation • Total liabilities= short term + long term debt
• A low ratio may indicate potential to finance new assets with debt

Ratio DEBT-EQUITY RATIO
Formula Total debt
Total Equity
Use Measures the extent of debt financing to equity.
Values Varies with industry.
<1.1 Strong
<2:1 Acceptable
<3:1 Evidence of weakness
>3:1 Weak
>4:1 Problems present
>6:1 Likely to fail
Interpretation • A higher ratio means :-
-Less long term stability
-Higher financial risk
-Lower long term debt capacity
• Higher business risk requires lower Debt Equity ratio
• Distorted by substantial intangible assets and off-balance sheet liabilities
• If too low, may be reducing potential Return on Equity

Ratio NET INTEREST COVER / TIMES INTEREST EARNED
Formula EBIT
Interest
Use Measures the extent of which earnings are available to meet interest payments
Values Varies with industry.
Larger is safer
>3:1 Strong
>2.5:1 Acceptable
>1:1 Evidence of weakness
<1:1 Problems present
Interpretation • A lower net interest cover means less earnings are available to meet interest payments and that the business is more vulnerable to increases in interest rates.
• Should consider stability and quality of earnings (and cash flow)

This entry was posted on Sunday, October 14th, 2007 at 11:16 pm and is filed under d. Interpretation. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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