leverage ratio

I don’t understand the financial leverage ratio, ie. why is avg total assets/total equity the leverage ratio? And why does ‘greater use of debt financing increase leverage and risk to shareholders and bondholders’? Thanks in advance. Your help is much appreciated.

This is my humble attempt to answer your question. When Assets > Equity, then you obviously have some leverage right? On this note, it seems obvious that the definition given by Schweser on Page 98 i.e. Financial Leverage = Total Assets / Total Equity seems plausible. When you are using more debt, that increases the liabilities and if liabilities increases faster than Assets, Net Income (NI = A - L) will be decreased. The main reason for debt is to close the gap between how much capital the owners can come up with and the amount the business needs. Using owners’ equity as the basis for borrowing is referred to as financial leverage. Hence by using/increasing debt (raising capital by issuing bonds etc…), you are also increasing the burden on the shareholders as you use their equity as financial leverage. Hence to raise in debt corresponds to raise in financial leverage. Debt is obviously more illiquid and hence I believe is considered risker. Hope this answers your question. If not, I’m hoping someone would correct me and I will learn from that. I’m glad that I tried at least :slight_smile: Good Luck!

Well, I thought I’d correct myself on the reason why it’s risky. I believe that it’s risky as you have to pay off the debt at some point and in the mean while you also have to pay the interest. I’m not sure if there is any risk of defaulting involved.

Let me try to express my idea, correct me if I am wrong Generally speaking, a company has two forms of capital to fund asset in order to make profit, the two forms of capital are debt and equity, as we know none of capital is free. therefore it’s very important for the company to understand the leverage ratio, the most popular leverage ratio is debt to equity ratio, it simply measures how much of the company’s equity has been financed by debt. If this ratio is too high, it simply means the company is under heavier debt obligation. Why will higher leverage ratio bring higher risk to the shareholders? Simply because the shareholders care about net income from the income statement, the more debt the more interest expense, the less net income will be remained for the shareholders. therefore, the higher leverage ratio the more risker for the shareholders of the company. But for the company, we can’t simply say it’s bad to have higher leverage ratio. for example, under the good economy, the company normally will generage more profit, as the interest expense is fixed. therefore the company will have higher return on equity (ROA), yet under the bad economy, it’s smart to have lower debt. I hope it make sense to you.

leverage is an artificial steroid for ROE improvement – that is what they want you do get out of this. Decompose the ROE into its 607 permutations and then determine where the company is doing well and not so well. ’

wshi68 Wrote: ------------------------------------------------------- > Let me try to express my idea, correct me if I am > wrong > > Generally speaking, a company has two forms of > capital to fund asset in order to make profit, the > two forms of capital are debt and equity, as we > know none of capital is free. therefore it’s very > important for the company to understand the > leverage ratio, the most popular leverage ratio is > debt to equity ratio, it simply measures how much > of the company’s equity has been financed by debt. > If this ratio is too high, it simply means the > company is under heavier debt obligation. > > Why will higher leverage ratio bring higher risk > to the shareholders? Simply because the > shareholders care about net income from the income > statement, the more debt the more interest > expense, the less net income will be remained for > the shareholders. therefore, the higher leverage > ratio the more risker for the shareholders of the > company. > > But for the company, we can’t simply say it’s bad > to have higher leverage ratio. for example, under > the good economy, the company normally will > generage more profit, as the interest expense is > fixed. therefore the company will have higher > return on equity (ROE), yet under the bad economy, > it’s smart to have lower debt. > > I hope it make sense to you.

The term is just a definition. Nothing more: borrow money so that you will be able to expand, improve, and grow. now, about risk added: debt has seniority over other forms of financing, that is, in the case of a company no longer being a going concern (no longer expected to operate indefinitely) or in difficulty paying short term obligations, in most of the cases, most of the states, under most laws, creditors have first right to recoup their funds (right after IRS or state/government body), followed by bond holders, preferred stock owners and the last of them all (if something remains) the common stock owners. That’s why the more leverage (the more debt on a company’s books), the higher the risk associated with the business (since returns higher than ROE, and definitely higher than the cost of debt itself have to be delivered) the higher the risk for bond holders and stock owners. Again, just like individuals, companies do have their “credit score” reflected in the cost of debt they can access.

Thank you all for your help. To quote cavil up there who said “When Assets > Equity, then you obviously have some leverage right” My question still is WHY do you have leverage when Assets > Equity? (Debt would be under Liabilities so why is assets used in the numerator of this leverage ratio?) AHH I know this is just a really easy concept but I just can’t put my finger on why!!! %\*&@(\*&*&^@$ thanks all…

daj224 Wrote: ------------------------------------------------------- > leverage is an artificial steroid for ROE > improvement – that is what they want you do get > out of this. Decompose the ROE into its 607 > permutations and then determine where the company > is doing well and not so well. ’ daj224, Could you pls explain me how to determine whether the company is doing well or not so well in term of ROE permutations by one example. Thanks a lot!

Dear Rockstar, I was trying to help you with the basic idea of ’ financial leverage’ to the best of my knowledge. Yes, borrowing money is accounted as Debt (Liabilities) however please put it aside for a moment. When you are successful in borrowing, the money will be accounted towards your assets. In order to guarantee that you will return the money you borrowed, you will use your equity. In short, You use Leverage to increase returns on equity. The point here is that by using leverage, there is a great potential for gain/loss. And how well the borrowing factor can only be decided by ROA, Interest rates, ROE. For example ROA > Interest rate, using leverage could be justified as ROE will be more too. On the flip side, ROE will be lower when ROA < Interest rate. You would as well not borrow if thats the case. Again, thats my understanding. Please correct me if you have a better answer or you think that I am not on the right track. I’d appreciate that! Good Luck

> > daj224, > > Could you pls explain me how to determine whether > the company is doing well or not so well in term > of ROE permutations by one example. > > Thanks a lot! Thu Thuy, Industry comparasions are one consideration the other being against previous periods. As you move through the material you will come across the Dupont Decomposition formulas. These will be very powerful tool in comparing ROE figures.

rockstar Wrote: ------------------------------------------------------- > Thank you all for your help. > > To quote cavil up there who said “When Assets > > Equity, then you obviously have some leverage > right” > > My question still is WHY do you have leverage when > Assets > Equity? (Debt would be under Liabilities > so why is assets used in the numerator of this > leverage ratio?) > > AHH I know this is just a really easy concept but > I just can’t put my finger on why!!! > %\*&@(\*&*&^@$ > > thanks all… The term “leverage” is used to capture the idea that if debt > 0; A>E. So, each dollar of equity controls a larger amount of Assets, and the profits (or loss) generated by a dollar of assets is captured by less than a dollar of equity. So, if D>0, ROE > ROA (assuming the firm is profitable). As for risk, debt increases the riskiness of the firm in two senses. First, a firm with debt could potentially end up in default if cash flows are insufficient to pay the required debt service. An all-equity firm dose not have this risk. There’s also a second sense in which debt makes a firm “riskier” - itr increases the variability of ROE. Here’s an example using real estate (it’s not exactly the same, but it captures the sense of it: Assume you had a house worth $100k with $0 debt. Assume you had a “return on assets” of 5% (i.e. the value of the house increases by 5%, to $105K). In this case, the “return on equity” (because there’s no debt) is also 5% (i.e. equity increases from $100k to $105K). Likewise, a 5% decrease in the value of the house results in a “return on Equity” of negative 5%. Now assume that the house was finance with 90% debt (a mortgage of $90K). In this cases, a 5% increase in the value of the house results in a 50% increase in the value of the equity (from $10,000 to $15,000). So, a 90% debt ratio results in an equity multiplier of 10x, with a resulting Return on Equity of 50%. Likewise, a 5% drop in the value of the house resutls in a 50% decrease in equity value. A 10% drop in the value of the house results in a wipieng out of the equity. So, A/E is just another way of presenting the Debt Ratio (D/A). In fact, A/E = 1/(1-D/A). It also equals 1 + D/E, BTW. Hope that helps.

Thank goodness. Good job, busprof. There’s some odd stuff up above…