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5.6: Leverage Ratios

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    Video - Audio - YouTube (Leverage Ratios start on slide 36.)

    The last group of financial ratios we will cover are the Leverage Ratios. Leverage Ratios are used to measure the amount of debt being used to support operations and the ability of the firm to service its debt. They are also referred to as Solvency Ratios and are similar to the Liquidity Ratios except they focus on long-term debt instead of short-term debt. Debt is often referred to as leverage. The idea is that you are using other people’s money to make money. You are using the borrowed money as a “lever” to increase your earnings. When one firm buys another firm using borrowed money, it is often referred to as a “leveraged buyout.”

    Debt-to-Equity Ratio

    The Debt-to-Equity Ratio is a measure of a company’s financial leverage calculated by dividing long-term debt by shareholders’ equity. It indicates what proportion of equity and debt the company is using to finance its assets.

                                  Long-term Debt
    Debt-to-Equity Ratio = ————————————————————————————
                            Total Stockholders’ Equity

    A higher Debt-Equity Ratio generally means that a company has been aggressive in financing its growth with debt. This can result in lower earnings as a result of the additional interest expense and hence, lower taxes. Sometimes investors use total liabilities instead of long-term debt. The lower the result, the better for the more risk averse investors. Of course, debt levels vary widely from industry to industry so, as with all ratios, we must always compare our results with competitors and what is customary for the particular industry.

    One noticeable event that we can see on the Balance Sheet of Sprouts is the change in Long-term Debt from 2018 to 2019. Long-term Debt jumped from $310 million to $1.63 billion. Sprouts joined a long list of companies who loaded up on Long-term Debt. Why? Interest rates had not been this low in generations. Many companies took advantage of the ultra-low interest rates to borrow. Will this mountain of debt come back to haunt them? That is something investors need to be aware of and do their best to anticipate. Currently, with a Long-term Debt of 1,400,000 and Total Stockholders’ Equity of 1,050,000, the Debt-to-Equity Ratio of Sprouts is 133.33%. Typically, businesses and individuals want to keep this ratio to no higher than 1.0 or 100%. Many individuals, Your Humble Author included, want it to be less than 0.5 or 50%. Obviously, the management of Sprouts does not seem concerned about this. We would want to consult what their management had to say about their debt situation in the annual report and other filings with the SEC.

    Times Interest Earned

    Time Interest Earned was Benjamin Graham’s favorite financial ratio. It measures the ability of a company to meet its fixed interest payments. A company can choose to stop paying dividends but interest payments on debt must be paid or else the company will be hauled off to bankruptcy court.

                             Earnings before Interest and Taxes
    Times Interest Earned = ————————————————————————————————————
                                     Interest Expense

    Times Interest Earned is used to determine how frequently interest payments are earned by the company during a year. The higher, the better. Normally, 3 or 4 is considered adequate. When you read The Intelligent Investor, you will see the master in action. Mr. Graham deftly shows how investors who pay special attention to this ratio can avoid some nasty surprises in the form of bankruptcies of the companies that they invest in.

    With Earnings before Interest and Taxes of 360,380 and an Interest Expense of 11,070, we find that the Times Interest Earned ratio is 32.55. Now we see why the management of Sprouts is not overly concerned with their debt level. Approximately every one and a half weeks, Sprouts is earning enough to pay their annual Interest Expense. That would be similar to an individual earning enough in one and a half weeks to pay their mortgage payments for the entire year.

    Total Debt-to-Total Assets Ratio

    The Total Debt-to-Total Assets Ratio relates how much of the company’s total assets have been financed by debt.

                                  Total Liabilities
    Total Debt-to-Equity Ratio = ———————————————————
                                    Total Assets

    Total Debt-to-Total Assets includes both short-term and long-term debt and assets. If it varies substantially from the Debt-Equity Ratio, the company may be relying heavily on short-term debt. A heavy reliance on short-term debt can denote more risk. Relying on short-term debt to finance a long-term operation is akin to someone financing their start up business using credit cards. Although it might be the only way they can get financing, it is very pricey and dangerous.

    Sprouts has Total Liabilities of 2,380,120 and Total Assets of 3,466,000. The resulting Total Debt-to-Total Assets ratio is 68.67%. For investors with an aversion to too much debt, this might be something of concern. Generally, investors concerned about excessive debt want to see this number less than 0.5 or 50%.

    Total Debt-to-Capitalization Ratio

    Finally, the Total Debt-to-Capitalization Ratio is used to measure the total amount of outstanding company debt as a percentage of the firm’s total capitalization.

      Total Debt                 Short-term Debt + Long-term Debt
         -to-      = ————————————————————————————————————————————————————————
    Capitalization    Short-term Debt + Long-term Debt + Shareholders Equity

    Similar to the Total Debt-to-Total Assets ratio. As with the other debt ratios, the higher the debt level, the more risk of insolvency. However, some industries with high rates of debt such as utilities also have more reliable earnings. As always, we must compare our results with the competitors and the industry as a whole.

    For Sprouts, we add the Short-term Debt of 136,600 to the Long-term Debt of 1,400,000 to get a subtotal of 1,536,600 for the numerator. In the denominator, we add the Short-term Debt of 136,600 and Long-term Debt of 1,400,000 to the Total Shareholders’ Equity of 1,050,000 to get 2,586,600. Dividing the numerator by the denominator gives us a Total Debt-to-Capitalization Ratio of 59.41%, a bit less than the Total Debt-to-Total Assets Ratio above.

    This page titled 5.6: Leverage Ratios is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Frank Paiano.