Leverage

Leverage Ratios
The Long term Lenders/Creditors would

judge the financial soundness of firm measured in terms of;

1) Ability to repay the installment of principal. 2) Regular payment of interest. Leverage Ratios determines the long term Solvency of the firm.
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Leverage Ratios
Computed from BALANCE SHEET Debt-Equity Ratio Debt-Assets Ratio Computed from PROFIT & LOSS A/C Interest Coverage Ratios Total Fixed Charge Coverage Ratio

Debt-Total Capital Ratio

Debt-Service Coverage Ratio(DSCR)

Dividend Coverage Ratio

Proprietary Ratio Capital Gearing Ratio

Debt-Equity Ratios
Measure the ratio of Long term Debt or Total Debt to Shareholders Equity.
This ratio reflects:

Relative claims of Creditors & Shareholders

against the Assets of the company. Relative proportion of Debt & Equity in financing the Assets of the firm.
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Debt-Equity Ratios
1)

D/E Ratio = Long Term Debt ----------------------Shareholders Equity D/E Ratio = Total Debt ----------------------Shareholders Equity

2)

Useful from Creditors , Owners & Firm point of view

Indicates Margin of safety to creditors
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Trading on Equity(Leverage)
It is the use of borrowed funds in

expectations of higher return to Equity Shareholders.

Both High & Low D/E ratios are not desirable.

Debt-Assets Ratio

= Total Debt ------------Total Assets

Debt-Total Capital Ratio

= Long Term Debt --------------------Permanent Capital(Capital Employed)

Proprietary Ratio
Indicates the extent to which Assets are financed by

Owners Funds. = Shareholders Funds ------------------------Total Assets

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Capital Gearing Ratio

= Equity Funds ----------------Fixed cost bearings securities Highly geared mean lower proportion of equity. Low geared means high proportion of equity as compared to fixed cost bearing capital.

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Coverage Ratios
Measures the firms ability to pay certain fixed

charges like: Interest on loan Preference dividends Repayment of Principal amount

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Interest Coverage Ratio

Also Called Time-Interest Earned Ratio.
Measures the firms ability to make contractual

interest payments.
Interest Coverage = EBIT(Earnings before Interest & Tax)

---------------------------------------Interest

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Total Fixed Charge Coverage Ratio

Measures the firms ability to meet all fixed

payment obligations. = Profit before Interest and Tax -----------------------------------------------------Interest + Repayment of loan/(1-Tax rate)

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Total Cash Flow Charge Coverage Ratio

Measures the firms Cash Resources to meet all

fixed payment obligations. = Profit before Interest and Tax + Depreciation -----------------------------------------------------Interest + Repayment of loan/(1-Tax rate)

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Debt Service Coverage Ratio

Measures the Debt Service Capacity of a firm.
Ability of the firm to make contractual payments

required on a schedule basis over the life of Debt.

PAT + Depreciation + Annual Interest on Long Term Loans & Liabilities = ---------------------------------------------------------------------------------

Annual interest on Long Term Loans & Liabilities + Annual Installments payable on Long Term Loans & Liabilities

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Test
To measure a firm's solvency as completely as possible, we

need to consider:

The firm's relative proportion of debt and equity in its

capital structure The firm's capital structure and the liquidity of its current assets The firm's ability to use Net Working Capital to pay off its current liabilities The firms leverage and its ability to make interest payments on its long-term debt The firm leverage and its ability to turn its assets over into sales
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Test
If sales decrease and financial leverage increases, we

can say with certainty that the profit margin on sales will decrease.
a. b.

True False

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Test
Which of the following is considered a profitability measure?
Days sales in inventory Fixed asset turnover Price-earnings ratio Return on Assets

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Test
Since ROA measures the firm's effective utilization of

assets (without considering how these assets are financed), two firms with the same EBIT must have the same ROA.
a. b.

True False

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Test
If a firm has $100 in inventories, a current ratio equal

to 1.2, and a quick ratio equal to 1.1, what is the firm's Net Working Capital?
$0 $100 $200 $1,000 $1,200
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Test
A Company has Net Worth of Rs.5 Lac, Term Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and Current Assets are Rs.25 Lac. There is no intangible Assets or other Non Current Assets. Calculate its Net Working Capital.

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Test
Perry Technologies Inc. had the following financial information for the past year: Inventory turnover = 8 Quick ratio = 1.5 Sales = $880,000 Current ratio = 1.75 What were Perrys current liabilities? a. $440,000 b. $500,000 c. $107,500 d. $ 61,429 e. $573,333

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Test
Current Ratio is say 1.2 : 1 . Total of balance sheet

being Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10 Lac. What would be the Current Liabilities?

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Test
Other things held constant, which of the following will

not affect the quick ratio? (Assume that current assets equal current liabilities.)
a. b. c. d.

Fixed assets are sold for cash. Cash is used to purchase inventories. Cash is used to pay off accounts payable. Accounts receivable are collected.

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Test
A decline in the inventory turnover ratio suggests that

the firm's liquidity position is improving.

a. b.

True False

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