Limited Time Offer: Save 10% on all 2022 Premium Study Packages with promo code: BLOG10

Calculate and Interpret Leverage and Coverage Ratios

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.

$$ \textbf{Leverage Ratios} $$

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

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.

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

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,

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

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop GMAT® Exam Prep


    Sergio Torrico
    Sergio Torrico
    2021-07-23
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    diana
    diana
    2021-07-17
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    2021-07-16
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    2021-06-28
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Marwan
    Marwan
    2021-06-22
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    2021-05-10
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.