How is average total assets / average total equity a measure of leverage? Help me wrap my arms around this please.
read about the equity multiplier
Say your total assets are $200 million and your total equity is only $100 million. You financed $100 million (leverage) to purchase $200 million in assets. If the ratio was 3 to 1 instead of 2 to 1 in the example I just wrote, you would be employing more leverage to buy those assets.
The balance sheet exclusive calculations of ‘leverage’ are hard to get my mind around too. I work in banking, so Leverage is always Debt/EBITDA – or some very similar cash flow metric. Going to be hard to unprogram work experience notions for the test.
MT327: Two answers to your question: 1) A/E is just a transformation of the D/A ratio. A/E = 1/(1- D/A), so higher leverage (debt as a percentage of assets) will result in a bigger “Spread” between assets and equity. In other words,higher A/E is equivalent to higher D/A. 2) Think of a “lever” - in the presence of debt, assets are greater than equity. So, a return on assets (Net Income/Assets) is 5% , that means a dollar of assets produces $0.05 ion Net Income. If your debt ratio (D/A) is 80%, that means a dollar of Assets is matched with $0.80 in debt and (Since A=D+E), $0.20 in equity. So, in this case, the $0.05 produced by a dollar in equity is matched with $0.20 in equity, resulting in a Return on Equity (NI/E) of 0.05/0.20 = 25% This means that your 5% ROA is levered up to a 20% ROE. By the way – This is also the logic behind the DuPont Equation (ROE = ROA x Equity Multiplier)
Avg.Assets/Avg.Equity is one way to find out how much debt is used to finance Assets. Example: If the value of the average asset is $ 10000 and the value of the average equity is 2000, then the financial leverage is 10000/2000 = 5. In other words, the debt used to finance assets is 10000/8000 = 1.25 (assuming that the remaining balance of 8000 is debt financing). The higher ratio 5 compared to 1.25 shows that the major source of financing comes from debts (only 20% from equity). This is a risk to shareholders as the creditors will have a main claim over assets.
I think I got it now. Thanks guys