Measures of Financial Leverage

The most commonly used measures of financial leverage are:

- Debt ratio.

L1 = D / (D+E) = D/V

Where D is value of debt, E is value of shareholders’ equity and V is value of total capital. D and E may be measured in terms of book value. The book value of equity is called net worth. Shareholder’s equity may be measured in terms of market value.

- Debt-equity ratio

L2 = D/E

- Interest coverage

L3 = EBIT/Interest

The first two measures of financial leverage can be expressed either in terms of book values or market values. The market value to financial leverage is theoretically more appropriate because market value reflects the current attitude of investors. But it is difficult to get reliable information on market values in practice. The market values of securities fluctuate quite frequently.

There is no difference between the first two measures of financial leverage in operational terms. They are related to each other in the following manner.

L1 = L2 / (1+L2) = (D/E) / (1+D)/E = D/V

L2 = L1 / (1-L1) = (D/V) / (1-D)/V = D/E

These relationships indicate that both these measures of financial leverage will rank companies in the same order. However, the first measure is more specific as its value will range between zeros to one. The value of the second measure may very from zero to any large number. The debt-equity ratio, as a measure of financial leverage, is more popular in practice. There is usually an accepted industry standard to which the company’s debt-equity ratio is compared. The company will be considered risky if its debt-equity ratio exceeds the industry standard. Financial institutions and banks also focus on debt-equity ratio in their lending decisions.

The first two measures of financial leverage are also measures of capital gearing. They are static in nature as they show the borrowing position of the company at a point of time. These measures, thus, fail to reflect the level of financial risk, which is inherent in the possible failure of the company to pay interest and repay debt.

The third measure of financial leverage, commonly known as coverage ratio, indicates the capacity of the company to meet fixed financial charges. The reciprocal of interest coverage, that is, interest divided by EBIT, is a measure of the firm’s income gearing. Again by comparing the company’s coverage ratio with an accepted industry standard, investors can get an idea of financial risk. However, this measure suffers from certain limitations. First, to determine the company’s ability to meet fixed financial obligations, it is the cash flow information, which is relevant, not the reported earnings. During recessionary economic decisions, there can be wide disparity between the earnings and the net cash flows generated from operations. Second, this ratio, when calculated on past earnings, does not provide any guide regarding the future risk ness of the company. Third, it is only a measure of short-term liquidity rather than of leverage.