Friday, July 08, 2011

Leverage Ratio

Gearing or leverage ratio measure the debt-equity relation in a company’s capital structure or the extent to which the company has made use of financial leverage.
A highly geared company is one which has a large amount of creditor fund in relation to its equity. A low geared company has a large equity and few borrowings. The ratio normally used for measuring leverage is the debt-to-equity ratio and the debt-coverage-ratio.

Debt to Equity Ratio
The debt to equity ratio (D/E) measures the relative proportion of creditor fund to shareholders’ equity fund. It reflects the company’s dependence on debt sources of financing and therefore the financial riskiness of the company for both bondholders and shareholders.

Debt Coverage Ratio
The debt coverage ratio measures the extent to which a firm has financed its assets with non-owner sources of fund. The example calculation for debt-coverage ratio is:

A debt coverage ratio of 50 per cent means that half of the company’s assets it’s financed with creditor funds.
In other words, the company’s assets are financed with an equal proportion of creditor fund to equity fund.

Debt to Equity Ratio (D/E)

Debt to equity ratio (D/E) is a measure of a company's financial leverage. It can be calculated as,

Debt to equity ratio

It indicates the proportion of debt the company is using to finance its asset with respect to shareholders equity.
To some extend, a company need to finance its business with debt either for expansion or loan repayment.
Higher D/E usually means the company has been aggressive in financing its growth with debt. This can result the volatile earnings from the additional interest expenses.

And bare in mind, company without debt doesn't necessarily better than company with debt.
Rule of thumb, good debt generates more cashflow, and bad debt doesn't.
Good debts are the money borrowed and spent directly for income-producing activities or assets; while bad debts used to pay off old debts or to increase its owner take home pays, to buy private jet for personal use or to renovate directors' office unnecessarily.
Although D/E have little to do with the growth prospect, it is useful in determining whether the company has strong financial position to survive through a tough time.

By nature of certain industries, you will find that some has high D/E while others might have lower. So, you should compare it to its peers within the same industries.
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