Leverage Ratio: Debts-Equity Ratio

June 8th, 2006 Comments off
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Continued from my last article, we now look at the financial 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.

 

 

DEBT-EQUITY RATIO

FORMULA

Total Debts / Total Equity

MEASURE  WHAT

Measures the extent of debt financing to equity

SCORE OR VALUE

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

SALIENT POINTS TO NOTE:

i. A higher ratio means :-

  •  Less long term stability

  •  Higher financial risk

  •  Lower long term debt capacity

ii.  Higher business risk requires lower Debt Equity ratio

iii. Distorted by substantial intangible assets and off-balance sheet  liabilities

 

iv. If too low, may be reducing potential Return on Equity

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Financial Accounting

 
 

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