Monday, September 6, 2010

Leverage Measurements

There are many ways to measure how leverage a company can be.

For bond holders, they will typically be interested to know the liquidation value of the company since bondholders are senior to equity in their claim for assets on liquidation. The debt ratio will provide such a measure:-

Debt Ratio = Total Liabilities / StockHolder' Equity

To get a measure of the amount of leverage taken on by a company relative to its size, the Debt-to-Equity or Leverage ratio would provide such a measure. It disregard current liabilities as such liabilities are day-to-day related and short-term.

Leverage Ratio = Long Term Debt / StockHolder's Equity

To get a measure of whether a company can service its debt, the interest cover ratio will be useful. Because earnings rise and fall depending on market and economic conditions, it would be preferable if the company’s earnings were much higher than interest expense in most years; otherwise, investing in the company would incur significant risk when the economy falters, as it always does eventually

Interest Cover Ratio = EBIT / Interest Expense of Long Term Debt

Some companies use EBITDA to calculate interest cover ratio, but you should be careful in those circumstances as the usual claim is always Depreciation and Amortization is not actual cash expense and does not affect the ability to pay debt interest.

No comments:

Post a Comment