Ratio Analysis: Evaluating Leverage

You now feel confident about the loan for Daisy Ltd. but are worried about what debt covenants might mean for your business. The bank has placed requirements on liquidity, solvency, leverage, and interest coverage using the following ratios:

Debt to equity is a leverage ratio. Sometimes you will see leverage referred to as gearing; they mean the same thing. Remember that a company can borrow money from lenders by issuing Debt, or it can raise money from shareholders by issuing Common Shares. Leverage simply measures the ratio of liabilities to equity. Since liabilities carry strict terms of repayment and shareholdings are flexible with no repayment terms, the distinction between the two is important.

High leverage means that a company has high liabilities compared to equity, so the company is constrained by contractual cash flows. This is a risky position to be in. On the other hand, low leverage may mean that a company is not taking advantage of debt, which is usually a less expensive form of financing than share ownership. From a bank’s perspective, low leverage is preferred because it means the bank is more likely to get paid back.

Times Interest EarnedTimes Interest Earned:
An interest coverage ratio that indicates a company’s ability to pay interest as it comes due. Times interest earned is interpreted as the number of times interest can be paid with operating income and is calculated as operating income divided by interest expense. measures interest coverage. It is the number of times a company could pay interest owing using operating profit. A higher ratio is safer.

Let’s start with our sample company, Daisy Ltd.

Given past results, you forecast the following financial statement amounts for Daisy Ltd. at 31 December 20X1:

We will calculate current ratio, debt to total assets, debt to equity, and times interest earned for Daisy Inc. at 31 December 20X1. Next, we will Identify any expected breaches in debt covenants and discuss measures Daisy could take to stay onside the bank’s debt covenants. Remember that the company could have to repay the loan principal immediately if they do not meet these covenants!

Current ratio: 48,000 ÷ 35,648 = 1.346

Debt to total assets: (35,648 + 65,956) ÷ (48,000 + 115,000) = 101,604 ÷ 163,000 = 0.623

Debt to equity: 101,604 ÷ 61,396 = 1.65

Times interest earned = 145,500 ÷ 2,768 = 52.6 times

Analysis:

The company will have to work on increasing their assets, or decreasing their leverage over the next year, to stay on-side their liquidity and solvency ratios. Otherwise, they may be liable to pay the entire amount of debt immediately or be subject to financial penalty.

Let’s give this a try. I’ll do the first example, Good Eats Inc., and then it’s your turn!

My Turn:

The following financial statement balances relate to Good Eats Inc. at 31 December 20X1:

Financial Statement Line	Amount ($)
Current Assets	47,500
Non-Current Assets	97,500
Current Liabilities	45,000
Non-Current Liabilities	80,000
Equity	20,000
Operating Income	102,300
Interest Expense	5,266

Required:

Calculate the four required ratios: current ratio, debt to total assets, debt to equity, and times interest earned for Good Eats Inc. at 31 December 20X1. Identify any expected breaches in debt covenants, and discuss measures your company could take to stay inside the bank’s debt covenants. Remember that the company could have to repay the loan principal immediately if they do not meet these covenants!

Analysis:

Good Eats will need to work on increasing their assets to improve their solvency and liquidity. They could do this by selling shares, which would increase their cash (current asset) as well as their equity. This increase in equity would also improve their leverage. Operating income will also have to increase or else they will have to pay back their entire principal. Based on these factors, Good Eats should not pursue this loan.

Now it’s your turn. How well do Cleo’s Swimwear and Mindful Media use debt?

Fantastic; now try Mindful Media!

Excellent; well done!!! That’s the end of our introduction to financial accounting journey. If you have enjoyed your accounting studies, I hope you will consider taking more accounting courses. Accounting is incredibly useful in day-to-day life because it expresses economic realities in practical ways. And there are many rewarding careers available for students who apply themselves to accounting study. All the best as you move forward in your studies and career!