Leverage Ratios

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Leverage RatioDescriptionWhen to UseExampleFormula
Debt-to-Equity RatioMeasures the proportion of a company’s debt relative to its shareholders’ equity.Assess the company’s financial leverage and risk.A debt-to-equity ratio of 0.5 indicates 50% of financing comes from debt.Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity
Debt RatioRepresents the proportion of a company’s assets financed by debt.Evaluate the extent to which assets are financed by debt.A debt ratio of 0.4 suggests 40% of assets are financed by debt.Debt Ratio = Total Debt / Total Assets
Equity RatioMeasures the proportion of a company’s assets financed by equity.Assess the extent of assets financed by equity.An equity ratio of 0.6 suggests 60% of assets are financed by equity.Equity Ratio = Shareholders’ Equity / Total Assets
Debt-to-Assets RatioIndicates the proportion of a company’s assets financed by debt.Evaluate the company’s reliance on debt for asset financing.A debt-to-assets ratio of 0.4 suggests 40% of assets are financed by debt.Debt-to-Assets Ratio = Total Debt / Total Assets
Debt-to-Capital RatioMeasures the proportion of a company’s total capitalization financed by debt.Assess the contribution of debt to the company’s total capital.A debt-to-capital ratio of 0.3 indicates 30% of total capital is debt-financed.Debt-to-Capital Ratio = Total Debt / (Total Debt + Shareholders’ Equity)
Debt Service Coverage Ratio (DSCR)Evaluates a company’s ability to cover its debt obligations with its operating income.Assess the company’s capacity to meet interest and principal payments.A DSCR of 2 suggests operating income is twice the amount of debt payments.DSCR = Operating Income / Total Debt Service
Interest Coverage RatioMeasures the company’s ability to cover interest expenses with its operating income.Evaluate the capacity to meet interest payments.An interest coverage ratio of 4 indicates operating income covers interest expenses four times.Interest Coverage Ratio = Operating Income / Interest Expenses
Times Interest Earned (TIE) RatioSimilar to the interest coverage ratio, it assesses the company’s ability to meet interest expenses.Assess the capacity to meet interest payments.A TIE ratio of 6 suggests income is six times interest expenses.TIE Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses
Fixed Charge Coverage RatioMeasures the ability to cover fixed charges (including interest) with operating income.Assess the capacity to meet both interest and lease payments.A fixed charge coverage ratio of 3 suggests income covers fixed charges three times.Fixed Charge Coverage Ratio = (Operating Income + Lease Payments) / (Interest Expenses + Lease Payments)
Capitalization RatioIndicates the proportion of a company’s long-term debt relative to its long-term debt and equity.Assess the relative weight of long-term debt in the capital structure.A capitalization ratio of 0.4 suggests 40% of the long-term capital is debt.Capitalization Ratio = Long-Term Debt / (Long-Term Debt + Shareholders’ Equity)
Financial Leverage RatioMeasures the proportion of a company’s assets financed by debt relative to equity.Evaluate the financial risk associated with asset financing.A financial leverage ratio of 2 suggests assets are financed twice as much by debt as by equity.Financial Leverage Ratio = (Total Assets / Shareholders’ Equity) – 1
Long-Term Debt to Total Capitalization RatioIndicates the proportion of a company’s long-term debt relative to its total capitalization.Assess the relative weight of long-term debt in the total capital structure.A long-term debt to total capitalization ratio of 0.3 suggests 30% of the total capital is long-term debt.Long-Term Debt to Total Capitalization Ratio = Long-Term Debt / (Long-Term Debt + Shareholders’ Equity)
Total Debt to Total Equity RatioMeasures the proportion of a company’s total debt relative to its shareholders’ equity.Assess the relationship between total debt and equity.A total debt to total equity ratio of 0.8 suggests total debt is 80% of shareholders’ equity.Total Debt to Total Equity Ratio = Total Debt / Shareholders’ Equity
Financial Debt RatioRepresents the proportion of a company’s financial debt (short-term and long-term) relative to equity.Assess the relationship between financial debt and equity.A financial debt ratio of 0.4 suggests financial debt is 40% of equity.Financial Debt Ratio = Financial Debt / Shareholders’ Equity
Debt-to-Income RatioMeasures the proportion of an individual’s income used to pay debt obligations.Evaluate an individual’s capacity to manage debt.A debt-to-income ratio of 0.3 suggests 30% of income is used to pay debt.Debt-to-Income Ratio = Total Monthly Debt Payments / Monthly Income
Debt Service RatioRepresents the proportion of an individual’s income used to cover debt service payments.Assess an individual’s ability to meet debt service obligations.A debt service ratio of 0.4 suggests 40% of income is used for debt service.Debt Service Ratio = Total Debt Service Payments / Monthly Income
Leverage IndexIndicates the degree of financial leverage in a company’s capital structure.Assess the level of financial leverage in the capital structure.A leverage index of 1.5 suggests a moderate level of financial leverage.Leverage Index = Total Capital / Total Equity
Degree of Financial Leverage (DFL) RatioMeasures the sensitivity of a company’s earnings per share (EPS) to changes in operating income.Assess the impact of changes in operating income on EPS.A DFL ratio of 2 means a 2% change in operating income leads to a 4% change in EPS.DFL Ratio = Percentage Change in EPS / Percentage Change in Operating Income
Operating Leverage RatioMeasures the sensitivity of a company’s operating income to changes in sales revenue.Assess the impact of changes in sales on operating income.An operating leverage ratio of 1.2 suggests a 1% increase in sales leads to a 1.2% increase in operating income.Operating Leverage Ratio = Percentage Change in Operating Income / Percentage Change in Sales
The Enlightened Accountant by Gennaro Cuofano – FourWeekMBADownload

Connected Financial Concepts

Circle of Competence

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The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

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Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

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The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

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Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

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Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

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Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

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Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

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Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

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Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

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Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

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Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

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Balance Sheet

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The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

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The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

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The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

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The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

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Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

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Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

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Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

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Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

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WACC

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The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

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A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

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