LEVERAGE RATIOS

Leverage ratios show the capital structure, that

is, how much of the total assets of a company is
financed by debt and how much is financed by
stockholders’ equity.
Leverage ratios can also be used to measure the
company’s ability to meet long-term obligations.
A question may be raised as to what an
appropriate capital structure is, that is, a
combination of debt and equity for a
company.
The capital structure of a company is
influenced by the following factors:
 1. Nature of business
If a company is in risky business and operating
cash flows are uncertain like mining operations, it has
to be more conservatively financed.
If the business is characterized by stable cash
flows from rent are almost certain, then a more
aggressive capital structure can be considered.
Stable operating cash flows allow the company to
pay periodic debt amortizations.
 2. Stage of business development
A company which is just starting its operations
may encounter difficulties borrowing from banks.
Banks generally look for the historical performance
of a company in making decisions regarding loan
applications.
From the stockholders’ point of view, it is also
not good to start an operation with borrowed funds.
 When a company has already established its
foothold in its market and there are
opportunities to expand, then that may be a
good opportunity to partially use borrowed funds
to finance an expansion.
By this time, management should have been
more familiar with the business and can
anticipate possible problems.
 3. Macroeconomic conditions
If macroeconomic conditions are good as
measured by gross domestic product (GDP) and
this trend is expected to continue in the
foreseeable future, then management can take
a more aggressive stance in financing the
company’s operations to take advantage of the
opportunities.
 4. Prospects of the industry and expected growth
rates

If the industry where the company operates

has good prospects and growth rates are
expected to be high, management can consider
borrowing more to expand operations.
Otherwise, if the prospects are bleak, it is better
to have low debt ratios.
 5. Bond and stock market conditions
The ability of a company to raise more funds from
the stock market and the bond market also depends on
how bullish players are in these markets. If both markets
are doing well just like what the Philippines has been
experiencing over the last couple of years where its
stock market and bond market are both expanding, then
it is a good opportunity for the publicly listed companies
and even those which are not listed to tap both markets.
 6. Financial flexibility
Financial flexibility refers to the ability of a
company to raise funds, be it stock market or
the bond market, when the need for cash arises.
Companies which have low leverage ratios have
more financial flexibility as compared to
companies which have higher leverage ratios.
 7. Regulatory environment
There are operations which are heavily
regulated such as banks which are monitored
by the Bangko Sentral ng Pilipinas (BSP).
Banks, as required by BSP, have to maintain a
minimum level of capital adequacy ratio, a kind
of leverage ratio applied to banks.
 8. Taxes
Interest expense provides ta shield while
cash dividend does not provide tax shield.
Interest expenses are allowed to be deducted
from operating income to compute taxable
income. Therefore, interest expenses reduce tax
payments. Cash dividends are not allowed to be
deducted from the operating income in
computing taxable income.
 9. Management style
Some managers are aggressive and
some are conservative. Management style
definitely contributes to the kind of capital
structure a company has. Management
recommends to the Board of Directors the
major financing activities a company will
embrace.
 The following leverage ratios will
be discussed in this chapter:

1. Debt ratio
2. Debt to equity ratio
3. Interest coverage ratio
 Debt ratio

Debt ratio measures how much of the

total assets are financed by liabilities.

Debt Ratio = Total Liabilities ÷ Total Assets

Let us compute the debt ratio of JSC Foods
Corporation in 2014.

Debt Ratio = 9 819 461 ÷ 22 298 020

Debt Ratio = 0.44
The debt ratio of less than 0.50 means that the
company has less liabilities as compared to its
stockholders’ equity. If the debt ratio is 0.50, this
means that the amount of total liabilities is exactly
equal to stockholders’ equity.
 Debt to Equity Ratio
Debt to equity ratio is a variation of the debt
ratio. A debt to equity ratio of more than one
means that a company has more liabilities as
compared to stockholders’ equity.

Debt to Equity Ratio = Total Liabilities ÷ Total

Stockholders’ Equity
Debt to Equity Ratio = 9 819 461 ÷ 12
478 559
Debt to Equity Ratio = 0.79

Since the company’s debt ratio is less

than one, it is expected that the debt to
equity ratio is less than one.
 Interest Coverage Ratio
Interest coverage ratio provides information if
a company has enough operating income to cover
interest expense.

Interest Coverage Ratio = EBIT ÷ Interest Expense

EBIT- earnings before interest and taxes

Interest Coverage Ratio = 4 048 696 ÷ 250 000
Interest Coverage Ratio = 16.19
The interest coverage ratio of 16.19 means that
JSC Foods Corporation has more than enough
operating income or earnings before interest and
taxes to cover its interest expense. It has EBIT
which is a little more than 16 times its interest
expense in 2014. This high interest coverage ratio is
also a reflection of a more conservative capital
structure JSC Foods Corporation has.
Efficiency Ratios or Turnover Ratios
Efficiency ratios, otherwise known as turnover
ratios, are called as such because they measure
the management’s efficiency in utilizing the assets
of the company.
 Total asset turnover ratio
 Fixed asset turnover ratio
 Accounts receivable turnover ratio
 Inventory turnover ratio
 Accounts payable turnover ratio
 Total Asset Turnover Ratio
Total asset turnover ratio measures the
company’s ability to generate revenues for
every peso of asset invested. It is an
indicator of how productive the company
is in utilizing its resources.
Asset Turnover Ratio = Sales ÷ Total Assets
Asset Turnover Ratio = 52 501 085 ÷ 22 298
020
Asset Turnover Ratio = 2.35

The asset turnover ratio of 2.35 means that

for every ₱1.00 of asset JSC Foods Corporation
has in 2014, it is able to generate sales of
₱2.35.
 Fixed Asset Turnover Ratio
This can be applied to companies which are
characterized by high PPE such as utility
companies, like telecom companies, power
generation and distribution companies, and
water distribution companies.
Fixed Asset Turnover Ratio = Sales ÷ PPE
Fixed Asset Turnover Ratio = 52 501
085 ÷ 12 200 000
Fixed Asset Turnover Ratio =4.30
In 2014, JSC Foods Corporation was
able to generate ₱4.30 for every ₱1.00
of PPE that it has.
 Accounts Receivable to Turnover Ratio

Accounts receivable turnover ratio

measures the efficiency by which accounts
receivable are managed. A high accounts
receivable turnover ratio means efficient
management of receivables.
A/R Turnover Ratio = Sales ÷ A/R
 If there are different types of receivables,
consider only the trade account receivable.
These are the accounts receivable created in
the ordinary course of business. Also, if there
are allowances for doubtful accounts, use the
gross amount of trade accounts receivable.
This amount is generally found in the notes to
financial statements where more information
about accounts receivables is disclosed.
A/R Turnover Ratio = Sales ÷ A/R
A/R Turnover Ratio = 52 501 085 ÷ 2 300
500
A/R Turnover Ratio = 22.82
This 22.82 accounts receivable turnover
ratio can be converted to days by dividing
360 days by the accounts receivable
turnover ratio.
Average Collection Period = 360 ÷ 22.82
Average Collection Period = 15.78 or 16
days
In 2014, JSC Foods Corporation had an
average of 16 days collecting its accounts
receivable. This means that from the day
the sale was made, it took the company 16
days, on the average, to collect its accounts
receivable.
 Inventory Turnover Ratio
Inventory turnover ratio measures the
company’s efficiency in managing its inventories.
Trading and manufacturing companies and
companies that are dealing with highly
perishable products and those are prone to
technological obsolescence must pay close
attention to this ratio to minimize losses.
Inventory Turnover Ratio = Cost of Sales ÷
Inventories
For manufacturing companies that may
have three types of inventories--- finished
goods, work in process, and raw materials
inventories--- all must be included in the
computation. This is to measure the
company’s level of efficiency in managing
this account.
Inventory Turnover Ratio = Cost of Sales ÷
Inventories
Inventory Turnover Ratio = 41 954 730 ÷ 4 849
304
Inventory Turnover Ratio = 8.65

Days’ Inventories = 360 ÷ Inventory Turnover

Ratio
Days’ Inventories = 360 ÷ 8.65
Days’ Inventories = 41.62 or 42 days

This 42 days’ inventories means that in

2014, JSC Foods Corporation took 42 days,
on the average, to sell its inventories from
the time they were bought.
 Accounts Payable Turnover Ratio
The accounts payable turnover ratio
provides information regarding the rate by
which trade payables are paid. Any
operating company will prefer to have a
longer payment period for its accounts
payable but this should be done only with
the concurrence of the suppliers.
Accounts Payable Turnover Ratio =
Cost of Sales ÷ Trade Accounts Payable
Accounts Payable Turnover Ratio = 41
954 730 ÷ 5 050 810
Accounts Payable Turnover Ratio =
8.31
 Ideally, purchases should have been the
numerator in the formula, but this amount
is not readily available in the income
statement. A close substitute for purchases
is the cost of sales or sometimes called
cost of goods sold. Purchases are definitely
a function of sales and cost of sales is a
function of sales. Given this line of
reasoning, cost of sales can be a very good
substitute for purchases.
Days’ Payable = 360 ÷ Accounts Payable
Turnover Ratio
Days’ Payable = 43.32 or 43 days

This number suggests that in 2014, the

average payment period of the company
for its trade accounts payable was 43 days.
Operating Cycle and Cash Conversion Cycle

By adding the average collection period and

days’ inventories, the operating cycle can be
computed. This operating cycle covers the
period from the time the merchandise is bought
to the time the proceeds from the sale are
collected. Managers of companies will prefer to
have a short operating cycle as compared to a
long one.
Operating Cycle = Days’ Inventories + Days’
Receivable
Operating Cycle = 42 + 16
Operating Cycle = 58 days
Chances are the company was given credit
terms. As our days’ payable suggests, payment to
suppliers averaged 43 days in 2014. If we are
interested to find out how long it takes the
company to collect receivables from the time the
cost of the merchandise sold was actually paid,
a cash conversion cycle or sometimes
called net trade cycle can be computed.

Cash Conversion Cycle = Operating Cycle

– Days’ Payable
Cash Conversion Cycle = 58 days – 43
days
Cash Conversion Cycle = 15 days
The cash conversion cycle is inversely related to
the operating cash flows. If the cash conversion
cycle is low, expect more operating cash flows
and the reverse is true.

Note that in the computation of total asset

turnover ratio, accounts receivable turnover
ratio, inventory turnover ratio, and accounts
payable turnover ratio, some references use
average balances in the denominators.
 For example, in the computation of total
asset turnover ratio, instead of using the
ending balance for the total assets,
average total assets can be used which is
computed as follows:

Average Total Assets = (Total Assets,

Beginning + Total Assets, Ending) ÷ 2
Vertical Analysis and
horizontal analysis
 Vertical Analysis
Vertical analysis or sometimes called
common-size analysis is an important financial
statement analysis tool. With vertical analysis,
all accounts in the statement of financial
position are presented as a percentage of total
assets while all accounts in the statement of
profit or loss are presented as a percentage of
sales or revenues.
 Horizontal Analysis
Horizontal or trend analysis is a
financial statement analysis technique
that shows change in financial
statement accounts over time.
Changes can be shown both in
absolute peso amount and in
percentage.
Peso Change = (Sales2014 – Sales2013)
Peso Change = 52 501 085 – 47 345 223
Peso Change = 5 155 862
% Change = ((Sales2014 - Sales2013) ÷
Sales2013) x 100%
% Change = (5 155 862 ÷ 47 345 223) x
100%
% Change = 10.89%
 These changes for the different
accounts are important to identify
trends. This horizontal analysis can be
done for the different accounts from
the SFP, statement of profit or loss,
and statement of cash flows.
 Quality of Earnings
• Is the income coming from the core
business?
• How much of the net income
translates into cash flows?
• Is the income stable?
Limitations of Financial Statement Analysis

1. Financial analysis deals only with

quantitative data.
2. Management can take short-run actions
to influence ratios.
3. Different companies may use different
accounting principles though they come
from the same industry.
4. Different formulas can be used in
computing financial ratios.
5. The amounts found in the financial
statements are already part of
historical data.
6. A financial ratio standing alone is
useless.