LEVERAGE, SOLVENCY, CAPITAL STRUCTURE, EARNING LEVERAGE RATIO:
Leverage> Leverage in general refers to the potential to earn a high level of return related to the amount of cost expanded.
2 types of leverages are,
1. financial leverage
2. operating leverage
FINANCIAL LEVERAGE:
It is a use of debt to increase earnings.
Interest is the cost of using debt.
Interest is a fixed charge
Interest must be paid whether are not the firm is profitable.
Financial leverage is successful if the firm earns more by investing in the borrowed fund than it pays in the interest to use.
FINANCIAL LEVERAGE IS MEASURED BY:
1. Financial leverage ratio
2. Degree of financial leverage
Financial leverage ratio:
It is also called an equity multiplier it indicates the amount of debt a firm is using to finance its asset’
=total asset÷total equity
Note: The more debt the company has the higher its financial leverage ratio [FLR] will be,
Borrowing money to finance assets will cost total assets to increase while total equity remains unchanged.
The company FLR will increase more money borrowed to finance additional assets.
Degree of financial leverage :
DFL =% CHANGE IN NET INCOME÷% CHANGE IN EBIT
The formula above can be used when 2 periods of financial information are available.
Or
DFL=EBIT÷EBT
The above formula can be used when only one period of financial information is available.
Note: for a given %by which EBIT increase, EBT, and net income will increase by that percentage multiplied by a factor equal to the DFL at that level of activity.
DFL is not a statistical measurement
DFL varies with its EBIT
As EBIT increases DFL decreases
Because the proportion increases in EBT greater than proportional in EBT is greater than the proportional increase in EBIT.
OPERATING LEVERAGE:
It measures the use of fixed operating costs to generate a greater operating profit.
It can be measured by the degree of operating leverage.
CAPITAL STRUCTURE SOLVENCY RATIO:
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Solvency means the ability of a firm to pay its long-term obligation.
Capital structure refers to the way a firm chooses to finance its business.
Should the company obtain finance by borrowing [by issuing bonds or borrowing from the banks] or by issuing equity shares or if both in what proportion?
CAPITAL STRUCTURE AND SOLVENCY RATIO: Include
Debt to equity ratio
Long-term debt-to-equity ratio
Debt to total asset
DEBT TO EQUITY RATIO
= total liability÷ total equity
It is a comparison of how much of the financing assets come from liabilities and equity.
Note: 2:1 means the company's total debt is twice its total equity.
LONG-TERM DEBT-TO-EQUITY RATIO
Total equity = current liability+non current liability
= long-term liability÷equity
Long-term liability = total debt liability- current liability
Long-term debt to equity measures how much long-term debt a company has compared to its total equity.
DEBT TO TOTAL ASSET RATIO:
=total liability÷total asset
Note: lenders and other creditors would like the debt-to-asset ratio to be as low as possible.
EARNING COVERAGE RATIO:
Its focuses on the company's earnings power.
It is related to financial leverage.
It measures the company's ability to generate earnings that will be the source of its interest payment, as well as other fixed payments.
It measures the relationship between fixed interest charges and earnings available to meet those charges.
It includes 3 ratios,
Interest coverage ratio
Fixed charge coverage ratio
Cash flow to fixed charge ratio
1. INTEREST COVERAGE RATIO:
It is also called the time's interest earned ratio.
Interest coverage ratio= EBIT÷ interest expense
For example on my youtube channel
Note: A high-interest coverage rate is desirable.
An interest coverage ratio of greater than 3.0 is excellent.
The further the ratio declines below 1.5, the higher risk of default becomes interest coverage ratio gives an indication of how much debt the company has available for the payment of its fixed interest expenses.
2. FIXED CHARGE COVERAGE RATIO:
It is also called the earnings-to-fixed charge ratio.
= earnings before fixed charge and tax ÷ fixed charge
FIXED CHARGE Include,
Interest expense on loans and financial leases.
Total payment on short-term and operating leases.
Principle payment on loans and financial leases.
earnings before fixed charge and tax :
=EBIT
+payment on short-term operating lease
=earning before fixed charge and lease
[example in my youtube channel]
3. cashflow to fixed charge ratio:
[not important]
=adjusted operating cashflow ÷fixed charge
Adjusted operating cash flow:
Operating cashflow+interest+tax+payment on short-term and operating lease+adjusted operating cashflow
Cashflow to fixed charge ratio
=adjusted operating cashflow÷fixed charge