Question

Explain how do financial analysts use ratios to analyze a firm’s leverage?

Answer 1

The financial analysts uses the ratios depicting the leverage position of a firm to analyse the firm's leverage, which are Debt ratio, Equity ratio, Debt-Equity ratio and Times interest earned. If all of these ratios are positive, it means that the firm is appropriately utilising the leverage ie. debt, to enhence the wealth of the owner ie. shareholders, of the firm

1) Debt Ratio = Total Liabilities/Total Assets , which provides the leverage (debt) used to finance the firm's assets.

2) Equity Ratio / Equity multiplier = Total Equity/Total Assets, which provides us the portion of firm's assets being financed through the shareholder's equity fund including the accumulated retained earnings.

3) Debt-Equity Ratio = Total Liabilities or debts / Total Equity, the implication of the ratio is that higher that 1 it is, the more leveraged the firm and the lower ratio shows the conservatism of the firm capital structure.

4) Times Interest Earned = EBIT / Annual Interest/Debt Expense, it shows how much the income is covering the interest expense of debt financing. Here we uses the Earning before interest and taxation as the measurement.

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