Different measures of financial leverage are the total debt to assets, debt to equity, and interest coverage ratios. These ratios are used to determine if the company will be able to meet its long-term financing obligations. The debt to asset ratio reveals which percentage of its assets is financed with its debt. The debt to equity ratio is used to determine if the proportion of debt and equity used is financing sources. The interest coverage ratio is used to determine if the company has enough earnings to cover the interest on its debt.
Debt to assets ratio is an important ratio for analyzing the company’s use of its debt for financing its assets. It is calculated by taking the company’s total debt and dividing it by its total assets. The debt includes both short-term and long-term debt obligations. Total assets include the company’s liabilities and equity. Therefore, the debt to assets ratio shows the percentage of its total assets that are financed with debt. The results will be between 0 and 1, which makes it easier to use as a benchmark of financial leverage when comparing with businesses within or outside its industry.
Debt to equity ratio is a measure of financial leverage that indicates the proportion of debt and equity used for financing its assets. This ratio is calculated by taking its total debt and dividing it by total shareholder’s equity. The total debt includes both long-term and short-term obligations. The book value of shareholder’s equity is normally used when calculating this ratio, but the market value usually yields more accurate results. Most industries have a standard debt to equity ratio for businesses to use as a benchmark.
Interest coverage ratio measures financial leverage by measuring its ability to pay interest on the debt. This ratio is calculated by dividing the earnings before interest and taxes, or operating income by the interest. This ratio can also use the market value instead of book value. Creditors commonly use this ratio to make sure in advance that the company will be able to afford paying its interest. Limitations of using this ratio are that it does not take into consideration the company’s cash flow and does not indicate whether there are potential risks.
Measures of financial leverage should be used with benchmarks in order to be the most useful. This can be done by comparing the ratio with the company’s historical results, competitors or industry averages. The use of different accounting methods can result in inaccurate comparisons when a company compares its ratio with those of its competitors or industry.
