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How to Calculate Leverage Ratios: Equity vs Debt - YouTube
Channel: Corporate Finance Institute
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There are several different ratios to use in order to assess the leverage
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of a company.
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The debt to equity ratio or debt to total capital ratio,
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compares how much of a company's funding comes from equity versus debt.
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To calculate the debt to equity ratio, we take the total interest bearing
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liabilities, including current and non current items, and divide them by
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total shareholders' equity.
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If the ratio is greater than a 100, it means the company has
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more financing coming from debt than equity. If however, we use the debt
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to total capital ratio, we take the total interest bearing liabilities and
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divide it by shareholders equity, plus total interest bearing liabilities.
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In this case, if the ratio is greater than 50%,
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it means more than half of the company's financing comes from debt.
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Debt to tangible net worth, takes the interest bearing liabilities and divides
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them by equity less intangible assets. This ratio is useful when it's important
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to understand how many physical assets a company has.
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The tangible net worth as the name implies, captures only the physical assets
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of the company and not the intangible ones.
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This tangible net worth number represents the proceeds that could be available
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if the company were to be quickly sold.
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A ratio of one times would be considered acceptable in most industries,
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however it's better to have the ratio less than one, and if it's
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greater than one, then some attention needs to be paid as to what's
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happening, and how the company is servicing that debt.
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Next, we have the total liabilities to equity ratio.
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In this case, we take all liabilities, including non interest bearing debts,
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for example, accounts payable would be included in total liabilities.
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This way, we can assess the company's obligations, including its short term
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working capital requirements, and then comparing that to the total amount
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of equity in the business. By using this ratio in conjunction with a
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debt to equity ratio, it is then possible to see the impact of
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operational activities on the business, meaning, is working capital tying
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up a lot of money on the balance sheet.
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Then we can look at total assets to equity.
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In this ratio, we take all of the assets and divide them by
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the equity. This is another way of slicing and dicing the leverage relative
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in this case to assets. This ratio can also be used in conjunction
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with a debt to equity ratio, in order to find the sweet spot
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with the right amount of leverage for the business.
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Finally, we have the debt to EBITDA ratio.
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This ratio unlike all of the other ones, requires the income statement in
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conjunction with a balance sheet. In this case, we take the total interest
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bearing liabilities and divide them by earnings before interest, taxes,
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depreciation and amortization.
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This is a common way of referring to how levered a company is,
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for example, is it levered at two, three or four times EBITDA.
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EBITDA is often used as a proxy to cash flow,
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even though as you all have learned in several other CFI courses,
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it may be very far from a true cash flow metric,
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since it does not include capital expenditures or any changes in working
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capital. But it is used quite frequently in the industry, and lenders often
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refer to the amount of leverage or the amount of gearing that a
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company can handle as a multiple of EBITDA.
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