P2A.2.3 Financial Ratios - Leverage Flashcards
Liquidity vs. Solvency
Liquidity = company’s ability to pay short-term debt as they fall due.
Solvency = company’s ability to pay long-term debt as they fall due.
Solvency has more equity than debt.
Types of Leverage Ratios
- Degree of Operating Leverage (DOL)
- Degree of Financial Leverage (DFL)
- Financial Leverage Ratio (FLR)
- Debt to Equity Ratio (DER)
- Debt to Total Assets Ratio (DTAR)
- Fixed Charge Coverage Ratio (FCCR)
- Interest Coverage Ratio (ICR)
- Cash Flow to Fixed Charges Ratio (CFFCR)
Degree of Operating Leverage Ratio (DOL)
- Operating leverage shows how well a company can pay it’s short-term obligations.
- Measures how the company’s operating income (EBIT) responds to changes in sales (revenue).
- The degree of operating leverage is affected by the company’s cost structure or composition of variable and fixed costs.
- A high degree of operating leverage indicates firm’s profit is more sensitive to sales.
Degree of Operating Leverage Ratio Formula
Single Period Ratio = Contribution Margin / Operating Income (EBIT)
Multiple Period Ratio = % Change in Operating Income (EBIT) / % Change in Sales
Note: a forecast for the next periods is needed to compute for the current year’s DOL or DFL.
Degree of Financial Leverage Ratio (DFL)
- Financial leverage shows how well a company can pay its long-term debt obligations.
- Measures how the company’s net income responds to changes in operating income (EBIT).
- The degree of financial leverage is affected by the company’s capital structure or composition of debt and equity.
- Since debt is financing with a fixed charge, the use of debt increases financial leverage.
Degree of Financial Leverage Ratio Formula
Single Period Ratio = Operating Income (EBIT) / Earnings Before Taxes (EBT)
Multiple Period Ratio = % Change in Net Income / % Change in Operating Income (EBIT)
Note: a forecast for the next periods is needed to compute for the current year’s DOL or DFL.
Financial Leverage Ratio (FLR)
- Known as the Equity Multiplier.
- Measures how many times the assets are available to shareholders (assets over equity).
- Higher debt proportion against equity leading to higher financial leverage, could mean a higher risk of default or insolvency.
Financial Leverage Ratio Formula
= Total Assets / Equity
Debt to Equity Ratio (DER)
- Measures the portion of total debt to total equity.
- Ratio that assess the level of assets that are financed by creditors (liabilities) against those that are financed by investors (equity).
Debt to Equity Ratio Formula
= Total Debt / Equity
Example:
DEF = $1MM/$2MM = 0.50
For every $1 per debt, there is $2 of equity invested.
Long-Term Debt to Equity Ratio
- Measures the percentage of assets financed by long-term (non-current liabilities) debt against the proportion of assets financed through equity.
Long-Term Debt to Equity Ratio Formula
= Long-Term Debt / Equity
Debt to Total Assets Ratio (DTAR)
- Debt to total assets ratio is the ratio of total liabilities over total assets.
- Measures the proportion of debt to total assets and how well creditors are protected in case of insolvency.
- From perspective of debt-paying ability, the lower this ratio, the better.
Debt to Total Assets Ratio Formula
AKA Debt Ratio
= Current Liabilities + Long Term Liabilities / Total Assets
= Total Debt / Total Assets
Fixed Charge to Coverage Ratio (FCCR)
- Measures the number of times a company’s earnings before fixed charges and taxes can cover its fixed charges.
- Fixed charges includes interest and principal installments on debt and leases; rent expense.
