Calculate and Interpret Leverage and Coverage Ratios

Solvency describes a company’s ability to meet its long-term debt obligations.

Leverage ratios and coverage ratios are the two primary types of solvency ratios that are used in evaluating a company’s level of solvency. Leverage ratios focus on the balance sheet and measure the extent to which liabilities, instead of equity, are used to finance a company’s assets. Coverage ratios focus, instead, on the income statement and cash flows and measure a company’s ability to cover its debt-related payments.

Calculation and Interpretation of Leverage and Coverage Ratios

The two primary types of solvency ratios are:

• Leverage ratios: measure the extent to which a company uses liabilities, instead of equity, to finance its assets.

• Coverage ratios: measure a company’s ability to cover its debt-related payments.

$$ \textbf{Leverage Ratios} $$

$$ \begin{array}{c|c} {\text{Debt-to-asset ratio}} & { \cfrac {\text{Total debt}^{\text A}} {\text{Total assets}} } \\ \hline {\text{Debt-to-capital ratio}} & { \cfrac {\text{Total debt}^{\text A}}{\text{Total debt}+\text{Total equity}} } \\ \hline {\text{Debt-to-equity ratio}} & { \cfrac {\text{Total debt}^{\text A}}{\text{Total equity}} } \\ \hline \text{Financial leverage ratio} & {\cfrac {\text{Average total assets}}{\text{Average equity}}} \\ \end{array} $$

^A  Debt is defined as the sum of interest-bearing short-term and long-term debt.

The first three leverage ratios use total debt in the numerator.

• The debt-to-assets ratio expresses the percentage of total assets financed with debt. Generally, the higher the ratio, the higher the financial risk and thus the weaker the solvency.
• The debt-to-capital ratio measures the percentage of a company‘s total capital (debt plus equity) financed through debt.
• The debt-to-equity ratio measures the amount of debt financing relative to equity financing. A debt-to-equity ratio of 1.0 indicates equal amounts of debt and equity, which is the same as a debt-to-capital ratio of 50 percent. Interpretations of these ratios are similar. Higher debt-to-capital or debt-to-equity ratios imply weaker solvency.

• The financial leverage ratio (also called the leverage ratio or equity multiplier) measures the amount of total assets supported by one money unit of equity.

$$ \textbf{Coverage Ratios} $$ $$ \begin{array}{c|c} \text{Interest coverage ratio} & { \cfrac {\text{EBIT}^{\text B}}{\text{Interest payments}} } \\ \hline \text{Fixed charge coverage ratio} & { \cfrac {\text{EBIT}^{\text B} + \text{Lease payments}}{\text{Interest payments} +\text{Lease payments}} } \\ \end{array} $$

^B  EBIT is earnings before interest and taxes.

• The purpose of the interest coverage ratio is to measure how many times a company‘s EBIT could cover its interest payments. The higher the interest coverage ratio, the more solvent a company is and this indicates a higher ability to service debt from operating earnings.
• The fixed charge coverage ratio measures how many time times a company‘s earnings (before interest, taxes, and lease payments) can cover the company‘s interest and lease payments.

Question

Dandy Dosh Company has shareholders’ equity of $200,000, short-term liabilities amounting to $50,000, and long-term liabilities of $75,000. Dandy Dosh’s financial leverage ratio is closest to:

1. 1.25.
2. 1.375.
3. 1.625.

Solution

The correct answer is C.

$$\text{Financial ratio} = \frac{\text{Average total assets}}{\text{Average shareholders’ equity}}$$

Where:

$$\text{Assets = Shareholders’ equity + Long-term liabilities + Short-term liabilities} = \$200,000 + \$75,000 + \$50,000 = \$325,000$$

Thus,

$$\text{Financial leverage ratio} = \frac{\$325,000}{\$200,000} = 1.625$$