AAKASHAYA PATRA SEVEN STAR SMART EDUCATION SERIES PART – 63 : 25.10.2020

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Financial Ratios - Leverage Ratios.

Leverage ratios measure the extent to which a company relies on debt financing in comparison to equity financing in its capital structure. Debt involves borrowing money to be repaid, plus interest,

while equity involves raising money by selling interests in the company.Companies normally prefer debt financing rather than equity financing. This is because of the cost of debt is lower than the cost of equity mainly because of one important fact that interest

payment on debt in tax deductible while the dividend paid to the equity shareholders is taxable.

However, debt creates with it a requirement for fixed payment in form of interest. That's not all;debt must at some point be repaid.In a situation when proceeds of debt can yield much higher return than the cost of debt, it may be wise to take on debt to fund the growth of the company. But at the same time if a company takes on too much of debt then the interest paid on the debt, then it might eat a substantial share of the profits earned by the company. When the scenario or business cycle turns to be unfavourable then with such debt load companies may face hard times.

Hence it can be said that there is a very thin line between the good and the bad debt. This is where the expertise and experience of a good management is verified. Inventory Some of the commonly used

LeverageRatios include

1. Interest Coverage Ratio

2. Debt to Equity Ratio

3. Debt to Asset Ratio

4. Financial Leverage Ratio

Interest Coverage Ratio:

The interest coverage ratio also known as debt service ratio helps us to measure a company's ability to meet its interest obligations on its outstanding debt.The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period.

Interest Coverage Ratio = EBIT / Interest Expense

This ratio tells us how much the company is earning relative to its interest burden. Hence we can determine how easily a company can pay interest on its outstanding debt.A low ratio indicates an inability to service debts, while too high a ratio indicates a lack of debt on company's balance sheet. Ideally, higher the value of interest coverage ratio, better it is. As a thumb rule, one should prefer investing in companies which have their interest coverage ratio much above 2.5.When a company's interest coverage ratio falls below 1.5

its ability to meet its interest expenses may be questionable and any downturn in business in such a condition can increase the possibility of default by the company on interest payments. In severe conditions

it can even lead the company to possible default or bankruptcy.An interest coverage ratio of below 1, indicates that company is currently facing difficulties generating the cash necessary to pay its interest obligations (i.e. interest payments exceed its earnings (EBIT)).Similarly for a loss making company this ratio will have a negative value.

Debt to Equity Ratio :

The Debt to Equity (D/E) ratio is another leverage ratio that compares company's liabilities to its stockholders' equity.The D/E ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders' equity.

 Debt to Equity Ratio = Total Debt / Shareholder's Equity

The lower the ratio better it is. The optimal debt to equity (D/E) ratio varies from one industry to another, but in general it should not be above 2.If this ratio is higher than that means, the company is getting more of their financing from borrowing which may pose a risk to it if debt levels are too high. A greater degree to which operations are

Funded by borrowed money means a greater risk of bankruptcy if business declines. If a company's debt to equity ratio is very close to zero it means company practically has no debt on its balance sheet.

In such cases we need to check whether the company does not need any debt as of now to manage its operations or lenders are not willing to give the company money. This can be found out by examining the capacity utilization of the company, its working capital requirements, operating cash flow and most importantly the credit rating of company.

FOR MORE SUCH TYPE OF EDUCATION JOINT OUR ONLINE SERIES AND BATCHES AND BE A PRO TRADER CONTACT ON 7028 421 786.

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