How to use leverage ratios when buying stocks
Leverage ratios measure the amount of debt a company has on its balance sheet relative to its equity and provide an indication of a company’s financial health.
Before buying stocks make sure you always analyze the debt exposure of the company as if it is excessive it could be risky. This is especially the case during economic downturns where a high level of leverage might lead a company to file for bankruptcy if it is not able to pay the interests to the creditors. This being said, debt isn’t necessarily a bad thing. It also might lead to higher future potential returns for the shareholders as it can help fuel the growth of a company.
For example, a company might take a loan from a bank or sell bonds in order to raise capital to buy new machinery that will make the production line more efficient, reducing the cost of goods sold and thus improving the gross and operating margin. The other way a company can raise capital to fuel its operations is through equity. The good thing about debt is that the interest payments are tax-deductible, whereas equity is not.
The important thing is to make sure a company does not have too much leverage (debt). You can evaluate a company’s level of debt at its ability to meet its obligations by using leverage ratios.
The two most basic leverage ratios are the debt ratio and the debt to equity ratio.
The debt ratio is calculated by dividing the company’s total liabilities by its total assets.
Debt ratio = Total liabilities / Total Assets
Although capital structures of companies can vary quite a bit from industry to industry, a debt ratio of no more than 0.5 is a good value. It means that half of its assets are financed through debt. If the company that you are evaluating operates in a capital-intensive industry even a higher value might be acceptable. Compare the value you come up with other companies’ debt ratios operating within the same industry. In general, a company with a debt ratio greater than 0.5 considered highly leveraged.
The debt to equity ratio, which measures the amount of a company that is financed by debt holders rather than equity holders, is calculated by dividing the company’s total liabilities by its stockholders’ equity.
Debt to equity = Total liabilities / Stockholders’ equity
A ratio of 1 would be the same of a debt ratio of 0.5.
The lower the two ratios, the less the company is dependent on leverage to fuel its business and the less risky the company stock. Recall that stockholders are residual claimants because bond holders and creditors have a first claim on the company assets. Highly leveraged companies are riskier because if they do not generate enough profits to pay the bond holders and creditors, they can be obliged to file for bankruptcy.
The debt ratio and debt to equity ratio, which can be calculated by taking a look at the balance sheet, will help you understand how much a company’s capital structure is dependent on leverage but it will not help with understanding whether a company will be able to meet its debt obligations or not. This can be measured with the interest coverage ratio which takes into account both the operating income and the interest expense. This ratio can be calculated by taking a look at the income statement.
Interest coverage ratio = Operating income / Interest expense
The higher the ratio, the greater the ability of a company to pay the interests to the debt holders. As for the debt ratio and debt to equity ratio, make sure you compare the interest coverage ratio with that of companies operating within the same industry as it can be very different from industry to industry. In general you should look for an interest coverage ratio of around 3. If it is around 1 or less then the company might be in a difficult situation.
Using leverage ratios in combination with other financial ratios such as profitability ratios, efficiency ratios, and liquidity ratios will provide you will a more complete view of the financial health of a company.