Leverage and Capital Structure
Leverage :refers to the potential to earn a high level of return relative
to the amount of cost expended.
• The problem with leverage is that it puts the company at risk.
• There are two types of leverage: financial and operating.
Capital structure :is how a firm chooses to finance its business
Solvency is the ability of the company to pay its long-term obligations
as they come due
1
Earnings Coverage :
ratios focus on the company’s earning power, because the company’s
earnings are the source of its ability to make interest payments and
principal repayments on debt.
1/Financial Leverage :
Financial leverage is measured by its financial leverage ratio and its
degree of financial leverage.
Financial Leverage Ratio (also called equity multiplier)
Total Assets
Total Equity
This ratio indicates the amount of leverage (use of debt) and also the
amount of risk that the firm has.
• The higher the debt, the higher this ratio will be
• As a firm increases its debt, it incurs more fixed interest charges. The
more fixed charges, the less income available for dividends and the
higher the risk that the firm cannot service its debt and will default.
Degree of Financial Leverage (DFL):
The degree of financial leverage is the factor by which net income
changes when compared to a change in earnings before interest and
tax, since interest on debt is a fixed expense
% Change in Net Income or
% Change in EBIT
2
Earnings Before Interest and Taxes (EBIT)
Earnings Before Taxes (EBT)
2/Operating Leverage (DOL)
Operating leverage is the % of a company’s total expenses that is
represented by fixed expenses.
Higher fixed expenses as a proportion of total expenses results in
higher operating leverage.
% Change in EBIT
% Change in Sales
or
Contribution Margin
EBIT
Degree of Total Leverage (DTL)
The degree of total leverage incorporates both operating and financial
leverage. The formula is:
DFL x DOL = DTL
% Change in Net Income
% Change in Sales
or
Contribution Margin
EBT
3
Capital Structure and Solvency Ratios.
1/debt to equity ratio:
Total Liabilities
Total Equity
This ratio is a comparison of how much of the financing of assets comes
from creditors and how much comes from owners, in the form of
equity
Long-Term Debt to Equity Ratio
the debt figure used is long-term debt only. Current liabilities, including
current maturities of long-term debt, are excluded.
Total Debt − Current Liabilities
Total Equity
Debt to Assets
Total Liabilities
Total Assets
4
Earnings Coverage Ratios
The Times Interest Earned Ratio, also called the interest coverage ratio,
compares the funds available to pay interest (i.e., earnings before
interest and taxes) with the amount of interest expense on the income
statement.
• This ratio gives an indication of how much the company has
available for the payment of its fixed interest expense.
• A ratio of 3 or better is good.
• A ratio below 1.5 indicates a higher chance of default.
It is calculated as follows:
Earnings Before Interest and Taxes (EBIT)
Interest Expense
