Leverage Ratios measure relative levels of financial risk taken on by creditors and shareholders of a business. This risk is based upon the fixed payment requirements of debt. They show how much protection the company’s assets provide for a creditor’s debt since all assets are funded by debt or equity. This is where the equation assets = liabilities + owner’s equity comes from.
The Debt-to-Worth Ratio shows the degree of protection that is provided by the company’s creditors. The higher the ratio, the more leverage there is in the company and the more of the company’s assets which are funded by debt. This measures the company’s ability to liquidate its assets in order to retire debt. It can also be used by the reader to measure how much a company can reduce the valuation of its assets before creditors may sustain a loss.
This ratio can vary greatly between industries and companies in an industry. It can also vary by how a company is set up. For instance, S-Corporations, partnerships and some LLCs are set up as a pass through entity where the tax liability is transferred from the corporate level to the personal partners or members. Often, distributions will be made to the owners to help them satisfy tax liability that was created by the company operation. This can reduce equity in the company.
The ratio is calculated as follows: Total Liabilities / Net Worth = Debt-to-Worth Ratio
If a company is in a negative equity situation or has assets with values that are lower than the total of the liabilities, that company is considered insolvent.
If we have a company with $2MM in liabilities and $1MM in equity then the Debt-to-Worth (D/W) is 2:1. So for every $1 the owners have at stake, the creditors have $2 at risk. These relative values could be much different if the market or liquidation values differ greatly from what is shown on the balance sheet.
The Debt-to-Tangible Worth Ratio is slightly more conservative than the D/W Ratio. This removes any intangible value from the equity side of the equation. If our company above had $500K of value in goodwill, a patent, trademark or other intangible asset, this would be removed from the equity side of the equation.
The calculation here is: Total Liabilities / (Net Worth – Intangible Assets) = Debt-to-Tangible Net Worth Ratio.
$2MM / ($1MM-500K) = 4:0 In this case you can see that removing the intangible assets makes the leverage increase.
The Long Term Debt to Net Fixed Assets Ratio measures the amount of debt that funds the fixed assets of the company. If you had a value of 0.54, then 54 cents of each dollar of assets is funded by debt; the other 46 cents is funded by equity.
The Debt-to-Capitalization Ratio is often used by bond rating agencies like Moody’s and S&P to measure the permanent capital of a company—its long term debt and net worth. This shows what percentage of the company’s permanent capital is financed with debt compared to equity. This ratio ignores any short term liabilities that may be tied to financing receivables or inventory and may be repaid by current asset turnover or seasonality changes. This also shows how the company is relying on long term debt which finances assets and the level of profitable operations to support the leverage. The calculation is as follows: Long-Term Debt / (Long-Term Debt + Net Worth) = Debt-to-Capitalization Ratio
If our example above has $1.5MM in long term debt and $1MM in net worth, the calculations would be as follows:
1.5MM / (1.5MM + 1MM) = 0.60 The company’s long term creditors would supply 60 cents and the investors would supply the other 40 cents of each dollar of capital.