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Importance of Leverage Ratio Calculation in Finance
Leverage ratios show the debt position of a company. Debt is an important part of finance for a firm. While debt is necessary to fund projects, excessive debt can be a sign of financial illness of a firm. In fact, both excess and too less availability of debt is detrimental for a firm.
As debt ratios show relationships with other items, they can be an eye-opener for management, owners, and investors. An optimum level of debt not only shows the good financial health of a company, but also means that the company would grow in the near and long-term future without much hindrance.
Following Statements Explain Why Calculating a Leverage Ratio is important −
Risk of a Project
Leverage ratios are also important because they show the financial risk of a project.
By using leverage ratios, one can check whether a firm has an overwhelming risk of meeting its goals in the future.
By knowing how much risk a firm can tolerate and checking it against leverage ratios that show the maximum debt load possible, stakeholders can determine whether a firm is in good financial condition.
This helps investors choose the best companies to invest in while owners and managers can take corrective actions to repair any future damage.
The Debt Trap
Leverage ratios also show whether a company is in a debt trap. In times of low profits, the firms may feel the heat of debt repayment. Sometimes, they may not be able to repay the debt. However, they may simultaneously need more debt to run their projects. Therefore, as it is in a trap, it needs to source debt on some very unfavorable terms. The companies should be aware not to fall into such a debt trap.
Leverage ratios can help companies pre-understand if it is going to fall into a debt trap, and thereby saving the resources and reputation of the company beforehand.
Importance for Creditors
A low debt-equity ratio is considered good by short-term creditors. Their aim is to get their investment and interest or premium back within a short time and a low debt-equity ratio shows a proportion where equity is more than the debt. So, the company is able to meet its short-term creditor demands easily.
Importance for Shareholders
From the point of view of shareholders, there is a disadvantage of low debt during good economic times for a firm. During such times, a proportion of low debt means low income for the shareholders if the company’s rate of return is more than the interest of the debt.
So, a good balance between debt and equity is essential for a company which is shown by the debt-to-equity leverage ratio.
Use of Preference Share Capitals
Some companies include preference share capital in their debt structure.
Depending on the purpose of calculating the leverage ratio, the preference share capital is either added to net worth or debt.
When preference share capital is used to show the leverage on ordinary shareholders’ earnings, the preference capital should be added to the debt.
A preference dividend is like an interest. It is fixed, and it helps shareholders’ debt to increase when the dividend capital rate is lower than the overall rate of return of the company’s project.
When preference share capital is used to show the financial risk, it should be added to net worth.
The use of preference share capital as debt ignores the fact that debt and preference share capital have different risk propositions for the shareholders. In one case failure in meeting payments means a probable bankruptcy while in the case of another there is no such risk. In the case of financial analysis, leverage is used to check risk. So, preference share capital should be included in net worth.
Lease Payments
When a company uses debt as long-term lease agreements, it is correct to include lease payments in debt while measuring a firm’s financial leverage.
Therefore,
$$\mathrm{Debt \:Ratio\:=\:\frac{Total \:Debt\: +\:Value \:of \:Lease}{Total \:Debt\:+\:Value \:of \:Lease\:+\:Net \:Worth}}$$
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