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
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FORMULA |
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Total Debts / Total Equity |
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MEASUREÂ WHAT |
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Measures the extent of debt financing to equity |
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SCORE OR VALUE |
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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 |
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SALIENT POINTS TO NOTE: |
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i. A higher ratio means :-
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ii. Higher business risk requires lower Debt Equity ratio |
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iii. Distorted by substantial intangible assets and off-balance sheet liabilities
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iv. If too low, may be reducing potential Return on Equity |