Leverage Ratios - An Overview
The use of leverage (debt) is a two-edged sword. Well-managed companies seek debt if they anticipate a situation in which the debt funds can be deployed in an environment that generates a higher return than the interest payments the company must make to service its debt. Remember that using debt to finance assets wisely increases the return on equity.
However, if a company incurs too much debt, the interest paid to service the debt reduces the shareholders' profit share. As a result, the line between good and bad debt is razor thin. Leverage ratios primarily address the overall extent of the company's debt and assist us in better understanding the company's financial leverage.
Let’s look at the following leverage ratios:
- Interest Coverage Ratio
- Debt to Equity Ratio
- Debt to Asset Ratio
- Financial Leverage Ratio
So far we have been using Grameenphone Limited as an example, however to understand leverage ratios, we will look into a company that has a sizable debt on its balance sheet. Let’s proceed with BSRM Steels Limited.
Interest Coverage Ratio:
The debt service ratio or debt service coverage ratio is another name for the interest coverage ratio. The interest coverage ratio informs us about how much the company earns in relation to its interest burden. This ratio indicates how easily a company can pay its interest payments. For example, if the company has an interest burden of BDT 100 versus an income of BDT 400, we know that it has enough funds to service its debt. A low interest coverage ratio, on the other hand, may indicate a higher debt burden and a higher risk of bankruptcy or default.
The formula to calculate the interest coverage ratio: [Earnings before Interest and Tax / Interest Payment]
The ‘Earnings before Interest and Tax’ (EBIT) = EBITDA – Depreciation & Amortization
Let us apply this ratio on BSRM Steels Limited. Here is the snapshot of the company’s P&L statement for the FY 22.
Now, EBIT = Revenue – COGS – Operating Expenses
= BDT (6700 Cr – 6000 Cr – 500 Cr)
= BDT 200 Cr
We know Finance Cost =BDT 170 Cr
Hence Interest coverage is = 200 / 170
= 1.17x
Interest coverage ratio of 1.17x suggests that for every BDT of interest payment due, BSRM is generating an EBIT of BDT 1.17.
Debt to Equity Ratio:
This is a relatively simple ratio. The Balance Sheet contains both of the variables needed for this calculation. It calculates the proportion of total debt capital to total equity capital. A value of 1 on this ratio indicates that debt and equity capital are both equal. A higher debt-to-equity ratio (more than 1) indicates greater leverage, and thus caution is advised. Lower than one indicates a relatively larger equity base in relation to debt.
The formula to calculate Debt to Equity ratio is: [Total Debt/Total Equity]
Please note, the total debt here includes both the short term debt and the long term debt.
Here is BSRM’s Balance Sheet where we glance at its total equity, long term, and short term debt:
Total debt = Long term borrowings + Short term borrowings
= BDT (490 + 4200 + 180) Cr
= BDT 4870 Cr
Total Equity is BDT 2500 Crs
Thus, Debt to Equity ratio will be computed as follows:
= 4870 / 2500
= 1.94
Debt to Asset Ratio:
This ratio assists us in understanding the company's asset financing pattern. It indicates how much of the total assets are financed by debt capital.
The formula to calculate the same is: Total Debt / Total Assets
For BSRM, we know the total debt is BDT 4870 Cr.
From the Balance Sheet, we know the total assets as 8190 Cr:
Hence the Debt to Asset ratio is: = 4870 / 8190 = 0.594 or 59.4%
This means roughly about 60% of the assets held by BSRM is financed through debt capital or creditors (and therefore 40% is financed by the owners). Needless to say, higher the percentage pf debt to asset, the more concerned the investor would be as it indicates higher leverage and risk.
Financial Leverage Ratio
When we discussed Return on Equity in the previous chapter, we briefly discussed the financial leverage ratio. The financial leverage ratio indicates the extent to which assets are supported by equity.
The formula to calculate the Financial Leverage Ratio is: Average Total Asset / Average Total Equity
From BSRM’s FY22 balance sheet, the average total assets is BDT (8100 Cr +7200 Cr)/2 = BDT 7650 Cr. The average total equity is BDT (2500 Cr + 2300 Cr)/2 i.e. BDT 2400 Cr (appx.). Hence the financial leverage ratio or simply the leverage ratio is:
7650/ 2400
= 3.18
This means BSRM supports BDT 3.18 units of assets for every unit of equity. Higher the number, higher is the company’s leverage and the more careful the investor needs to be.
