How do you evaluate a company's leverage ratios?

Member

by mazie , in category: Stocks and Equities , 9 months ago

How do you evaluate a company's leverage ratios?

Facebook Twitter LinkedIn Telegram Whatsapp

1 answer

by cedrick.casper , 9 months ago

@mazie 

To evaluate a company's leverage ratios, you can follow these steps:

  1. Calculate the debt ratios: Debt ratios indicate the proportion of a company's assets that are funded by debt. There are various types of debt ratios, including debt-to-equity ratio, debt-to-assets ratio, and debt-to-capital ratio. These ratios provide insights into the company's financial risk.


To calculate the debt-to-equity ratio, divide the total debt by the total equity of the company. For example, if the company has $100 million in debt and $200 million in equity, the debt-to-equity ratio would be 0.5 ($100 million / $200 million).

  1. Analyze the interest coverage ratio: This ratio measures a company's ability to meet its interest payments using its operating income. It looks at the proportion or multiple of operating income generated compared to the interest expenses incurred.


To calculate the interest coverage ratio, divide the company's earnings before interest and taxes (EBIT) by its interest expenses. For instance, if a company's EBIT is $10 million and its interest expense is $2 million, the interest coverage ratio would be 5 ($10 million / $2 million).

  1. Calculate the debt-to-assets ratio: This ratio indicates the proportion of a company's assets financed by debt. It helps analyze the percentage of a company's funds that are borrowed.


To calculate the debt-to-assets ratio, divide the total debt by the total assets of the company. For example, if the company has $50 million in debt and $200 million in assets, the debt-to-assets ratio would be 0.25 ($50 million / $200 million).

  1. Assess the debt-to-income ratio: This ratio measures the proportion of a company's income used to service its interest obligations. It provides an indication of the affordability of debt.


To calculate the debt-to-income ratio, divide the annual interest expense by the annual net income of the company. For example, if the company's annual interest expense is $5 million and its net income is $20 million, the debt-to-income ratio would be 0.25 ($5 million / $20 million).

  1. Compare the ratios: Once you have calculated these leverage ratios, compare them to the industry averages or the company's historical data. This will help you understand how the company's leverage ratios differ from its peers or its past performance.


By analyzing these leverage ratios, you can gain insights into a company's risk profile, financial health, and ability to repay its debt. However, it is essential to consider other factors such as the industry, economic conditions, and management strategies while evaluating a company's leverage ratios.