12.4: Leverage Ratios - Analyzing Financial Structure

The accounting equation expresses a relationship between assets owned by an entity and the claims against those assets. Although shareholders own a corporation, they alone do not finance the corporation; creditors also finance some of its activities. Together, creditor and shareholder capital are said to form the financial structureFinancial structure of a corporation. At December 31, 2021, the balance sheet of BDCC shows the following financial structure:

ASSETS	=	LIABILITIES	+	EQUITY
$2,486	=	$1,255	+	$1,231

Debt Ratio

The proportion of total assets financed by debt is called the debt ratio, and is calculated by dividing total liabilities by total assets.

OR

In BDCC's case, these amounts are:

		(000s)
		2021		2020
Total liabilities	(a)	$	1,255	$	917
Total assets	(b)	$	2,486	$	2,112
Debt ratio	(a/b)	0.5048:1 or 50.48%		0.4342:1 or 43.42%

In other words, 50.48% of BDCC's assets are financed by debt. Therefore, because assets are financed by debt (aka liabilities) and equity, we intuitively know that 49.52% of BDCC's assets must be financed by equity which is the topic of the next section.

Equity Ratio

The proportion of total assets financed by equity is called the equity ratio, and is calculated by dividing total equity by total assets. In BDCC's case, these amounts are:

		(000s)
		2021		2020
Total equity	(a)	$	1,231	$	1,195
Total assets	(b)	$	2,486	$	2,112
Equity ratio	(a/b)	0.4952:1 or 49.52%		0.5658:1 or 56.58%

In 2021, 49.52% of the assets were financed by equity while in 2020 56.58% of the assets were financed by equity. Generally, this is considered an unfavourable trend because as equity financing decreases, we know that debt financing must be increasing as evidenced by the debt ratio above. The greater the debt financing, the greater the risk because principal and interest payments are part of debt financing.

Notice that the sum of the debt and equity ratios will always equal 100% because of the accounting equation relationship: A = L + E where A = 100% and, in the case of BDCC, L = 43.42% in 2020 and E = 56.58% in 2020.

Debt to Equity Ratio

The proportion of creditor to shareholders' claims is called the debt to equity ratio, and is calculated by dividing total liabilities by equity. In BDCC's case, these amounts are:

		(000s)
		2021		2020		2019
Total liabilities	(a)	$	1,255	$	917	$	369
Equity	(b)	$	1,231	$	1,195	$	1,048
Debt to equity ratio	(a/b)	1.02:1		0.77:1		0.35:1

In other words, BDCC has $1.02 of liabilities for each dollar of equity at the end of its current fiscal year, 2021. The proportion of debt financing has been increasing since 2019. In 2019 there was only $0.35 of debt for each $1 of equity. In 2021, creditors are financing a greater proportion of BDCC than are shareholders. This may be a cause for concern.

On the one hand, management's reliance on creditor financing is good. Issuing additional shares might require existing shareholders to give up some of their control of BDCC. Creditor financing may also be more financially attractive to existing shareholders if it enables BDCC to earn more with the borrowed funds than the interest paid on the debt.

On the other hand, management's increasing reliance on creditor financing increases risk because interest and principal have to be paid on this debt. Before deciding to extend credit, creditors often look at the total debt load of a company, and therefore the company's ability to meet interest and principal payments in the future. Total earnings of BDCC could be reduced if high interest payments have to be made, especially if interest rates rise. Creditors are interested in a secure investment and may evaluate shareholder commitment by measuring relative amounts of capital invested. From the creditors' perspective, the more capital invested by owners of the company, the greater the relative risk assumed by shareholders thus decreasing risk to creditors.

Although there is no single most appropriate debt to equity ratio, there are techniques for estimating the optimum balance. These are beyond the scope of introductory financial accounting. For now, it is sufficient to note that for BDCC the debt to equity ratio has increased considerably over the three-year period which is generally unfavourable because of the risk associated with debt financing.

Times Interest Earned Ratio

Creditors are interested in evaluating a company's financial performance, in order to project whether the firm will be able to pay interest on borrowed funds and repay the debt when it comes due. Creditors are therefore interested in measures such as the times interest earned ratio. This ratio indicates the amount by which income from operations could decline before a default on interest may result. The ratio is calculated by the following formula:

Note that income from operations is used, so that income before deduction of creditor payments in the form of income taxes and interest is incorporated into the calculation. BDCC's 2020 and 2021 ratios are calculated as follows:

		(000s)
		2021		2020		2019
Income from operations	(a)	$	300	$	274	$	204
Interest expense	(b)	$	89	$	61		-0-
Times interest earned ratio	(a/b)	3.37:1		4.49:1		n/a

The larger the ratio, the better creditors are protected. BDCC's interest coverage has decreased from 2020 to 2021 (3.37 times vs. 4.49 times), but income would still need to decrease significantly for the company to be unable to pay its obligations to creditors. The analysis does indicate, though, that over the past two years interest charges have increased compared to income from operations. Creditors need to assess company plans and projections, particularly those affecting income from operations, to determine whether their loans to the company are at risk. As discussed above, it may be that significant investments in assets have not yet generated related increases in sales and income from operations.