Terms Beginning With 'l'

Leverage Ratio

  • January 07, 2020
  • Team Kalkine

What is Leverage Ratio?

Leverage Ratio is a quantitative measure indicative of the proportion of the business capital represented by debt. In other words, it highlights the extent to which a firm uses debts rather than equity for financing its operations. The leverage ratio is used for gauging the risk surrounding investment and evaluating if the company is able uphold its financial commitment. 

The leverage ratio also pinpoints the degree of backing provided by the equity capital to the debts of the company. Significantly, the leverage ratio varies with respect to the industry and company types. For example, in the airline industry, banking institutions, capital goods businesses, have substantially higher leverage ratio. Furthermore, the startups also have a high leverage ratio 

Good read: Understanding Types Of Leverage Ratios

What is the Concept of Leverage?

The term ‘leverage’ is generally used in relation to the investment strategy that uses loans or debt for financing its assets and overall increasing the return potential. At the same time, this strategy also increases the downside risk and makes the investment risky. This type of leverage represents financial leverage. 

The total leverage can be broken down into Operating Leverage and Financial Leverage. In simpler terms, the cost structure of the operations is responsible for operating leverage, while the capital structure of the company accounts for financial leverage. 

Notably, a high fixed cost leads to high operating leverage, and the high debt-level in the company’s capital structure denotes high financial leverage. 

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The use of leverage within the business can maximise both gains and losses. 

Why is Leverage Ratio Important?

Businesses at a certain point borrow funds by issuing bonds or taking loans from banks, in cases when

  • They do not possess substantial funds that are needed for pursuing operations or expansions
  • They want to leverage borrowings for increasing return potential

The objective of borrowing loan and debt is to maximise the wealth via investment. However, in case of investment failure, the business faces twofold challenges which include loss of the original investment and additional interests burden that must be paid to the lender. Thus, the objective of wealth maximisation is only attained if the return on investment is higher than the interest or cost of the debt capital.

Good read: What Is Return On Invested Capital (ROIC)? 

Concurrently, in case of investment failure, the lenders are also exposed to default risk, with the borrower unable to pay the principal or interest on the loan amount. In order to evade default scenario, the creditors evaluate the financial aptitude of the company using the leverage ratio. 

Watch: What are Interest Rates?

Also watch: What are the Key Determinants of Interest Rates?

Leverage ratio indicating a significantly very high proportion of debt can be a dangerous sign for both the investors as well as the company as it indicates chances of credit downgrades and bankruptcy. However, a very low leverage ratio may point towards a conservative approach taken by the management, typically, at the cost of growth. The leverage ratio sheds light on how the variability in the output could impact the company’s income. 

Leverage ratio is utilised not only by the management and the creditors, but the credit rating agency also use it for assessing the company’s overall health, its ability to fulfil obligations and analyse its future potential in terms of running a business and expanding. 

Must read: Role of rating agencies and their impact on your investments

What are the Types of Leverage Ratio?

Common Leverage Ratios

  1. Debt-to-Equity Ratio

The ratio gives the measure of the total business’ obligations with respect to the shareholder’s equity. The ratio indicates the extent of dependency of the company on the

debt capital for pursuing its undertakings. Creditors and investors use the ratio for analysing the credit worthiness of the loan or debt. 

High D/E ratio highlights that owners with limited capital investment can retain a significantly higher degree of control on the business. However, it potentially limits further borrowing opportunities. 

Total Debts represent debentures and long-term loans. Total Equity is the combination of shareholder’ Equity, Reserves and surplus and Retained Profits. 

  1. Debt-to-Capital Ratio

The ratio indicates the degree of financial leveraging used in financing the business operations by comparing its total obligations against the total capital. 

The ratio is calculated by dividing the Debt of the Company by the total capital, which represents the sum of the shareholder’s equity and total debt. 

High debt-to-capital ratio signifies the risky nature of the business. Nevertheless, it should be noted that the value of the ratio varies with respect to the industry and also if the company is new or old. 

  1. Debt-To-EBITDA Leverage Ratio

The ratio compares the financial borrowings of the company against the Earnings before Interest, Taxes, Depreciation and Amortisation (EBITDA). The ratio indicates the company’s ability to pay its debts by utilising the income generated from its operations. 

Total debt in the formula represents both long term and short-term debts. 

EBITDA= Net Income+ Interest Expenses+ Tax Paid+ Depreciation/Amortisation

  1. Debt to Assets Ratio

Debt to Assets Ratio indicates the proportion of the total assets that are financed by the liabilities of the company. Thus, it highlights the contribution of creditors in funding the assets of the company. 

The total debt in the above formula does not include shareholder’s capital. The ratio above 0.5 indicates that the company’s major proportion of the asset is financed using the borrowings rather than from the investor’s fund.  

Coverage Ratios 

  1. Interest Coverage Ratio

The interest coverage ratio indicates how well a company can pay the interest on its outstanding debt using the company’s operating profit, (EBIT)

The high-interest coverage ratio indicates company is well positioned to meet its interest obligations via the business operations. Significantly, lenders, investors and creditors evaluate the interest coverage ratio for ensuring if they will be paid their dues in a timely manner.

  1. Debt service coverage ratio

This ratio ascertains if the company will be able to pay its current debt obligations or debt service by means of its operating profit. Significantly, debt service includes the repayment of principal as well as interest on different debt types for a particular period.

Typically, DSCR of less than 1 signifies that the borrower will not be able to meet its current debt obligations from its business operations entirely. 

  1. Fixed-Charge Coverage Ratio

The fixed charge coverage ratio is the ability of the firm to cover fixed-charge obligations such as debt payment, and expense of leases and interest. 

The ratio gives a broader measure of the company’s ability to meet the current due, including fixed charges on leases, principal repayment along with the interest return. 

  1. Asset Coverage Ratio

The asset coverage ratio indicates how well the firm will be able to meet its borrowing obligations by selling the assets. 

The higher value of the ratio indicates that the company has more assets than the liabilities. The banks and creditors use the ratio to analyse the risk associated with lending the capital. 

Refers to most commonly the realty sector and indicates the rate of sale of homes in a certain market during a given period of time. It is calculated as the ratio of the average number of sales in a month by the total number of available homes.

What are accounts payable? Accounts payable is the amount of cash a company is liable to pay to its suppliers and clear dues. As current liabilities of the company, accounts payable is required to be settled over the next twelve months.  It also shows the obligations of the business over the next year. Accounts payable is required to be repaid in a short period, depending on the relationship with suppliers. It is essentially a kind of short term debt, which is necessary to honour to prevent default.  As a part of the company’s working capital, it is widely used in analysing the cash flow of the business and cash flow trends over a period. Accounts payable may also depict the bargaining power of the company with its vendor and suppliers.  A vendor or supplier may give the customer longer credit period to settle the cash compared to other customers. The customer here is the company, which will incur accounts payable after buying goods on credit from the vendor.  There could be many reasons why the vendor is providing a more extended credit period to the firm such as long term relationship, bargaining power of the firm, strategic needs of the vendor, the scale of goods or services.  By maintaining a more extended repayment period to supplier and shorter cash realisation period from the customer, the company would be able to improve the working capital cycle and need funds to support the business-as-usual.  However, prudent working capital management calls for not overtly stretching the payable days as it might lead to dissatisfaction of supplier. Also, investors tend to closely watch the payable days cycle to determine the financial health of the business. When the financial conditions of a firm deteriorate, the management tend to delay the payment to their suppliers. What is accounts payable turnover ratio? Accounts payable turnover ratio shows the capability of a firm to pay cash to its customer after credit purchases. It is counted as an essential ratio to analyse the cash management attribute of the firm and its relationship with vendors or suppliers.  It is calculated by dividing purchases by average accounts payable.  Purchases by the company are calculated as the sum of the cost of sales and net inventory in a given period:  Now let’s understand this the help of an example. Let us suppose, Cost of sales of Company XYZ for the period was $60,000, and XYZ began with inventories worth $21000 and ended at $15000. Accounts payable at the beginning was $20000, and $15000 at the end.  Now the purchases will be $66000 (60000+21000-15000). The average accounts payable will be $17500. Therefore, the accounts payable turnover ratio will be 3.77x.  Dividing the number of weeks in a year by the accounts payable turnover ratio will give the number of weeks the company takes on average to settle its payables. In this case, it will be around 13.8 weeks (52/3.77). 

Accounts receivable financing is a method of selling accounts receivables to obtain cash for the company's operations. Accounts receivable is one of the liquid assets and can be tracked using the quick ratio.

What is the Dark Web?  The dark web is one such portion of the World Wide Web which is not accessible by regular search engines. The dark web is considered a hotbed for criminal activities, and it is much more than that. Various websites exist on an encrypted network inside the dark web. Standard web browsers and programs cannot find these websites. Once inside the dark web, different sites and pages can be accessed like one does on the web. Scientists believe that the internet we see is only 4% of the entire ocean of the web, meaning the 96% consists of the "Deep and Dark Web".  The user interface used in the dark web is usually internet-based, but it utilises special software which is not part of the standard ones. There are dozens of web browsers to surf the internet, but they all work in the same way. These standard browsers use ports and protocols to request, transfer and view data on the Internet. The website you access may look familiar, but as you enter, it may be illegal or something familiar but otherwise not monitored by anyone else. Therefore, the deep web and the dark web are famous for being anonymous. Also read: Cyber Espionage Campaign: Strings that tie China, Australia and the US How to access dark web browser? In order to access a few areas which are restricted, the user may need a password and a process to follow. A special software called TOR (The Onion Router) or the Freenet has these non-standard connections. These browsers are unlike standard internet browsers and have a process to access. They allow the users to browse around the dark web and are focused on keeping the user identity anonymous. If hacked or accessed, the regular web browser can easily provide user information such as who the user is and whereabouts. Though the dark web is providing 100% anonymity, federal agencies have been successful in tracking down criminal activities on the dark web. It is often said that the person you are talking to on the dark web could either be an FBI agent or a criminal. Image: Kalkine   What happens inside the world of the dark web?  The dark web is famous for allowing sinister activities, but many users go on the dark web to access information which otherwise may not be accessible on standard internet. Such as users from extremely oppressive governments who cut access to the world for their citizens. Unfortunately, such confidential environments also provide open platforms to criminals, terrorists and other such individuals involved in illegal activities.   Hence, experts advise users to not access the dark web even out of curiosity as it is a lawless environment. There have been many incidents where innocent, curious users were trapped and forced to get involved in criminal activities or their digital devices hacked and compromised without their knowledge.  A study conducted by a University of Surrey researcher Dr Michael McGuires in 2019, Into the Web of Profit, shows that the dark web has become worse in recent times. Since 2016 of all the listings on the dark web suggested, 60% could harm companies. Everything illegal and criminal can be found on the dark web, it also has other legitimate options such as chess clubs or book clubs, but because of the anonymity, the user will not know whom he/she is interacting with. Inside the dark web, anonymity and lawless nature make the crimes which exist otherwise in our society hard to trace.  The payment procedure inside the dark web is also different from the World Wide Web. Most often, Bitcoin and Monero cryptocurrency are used for the transactions.    RELATED READ: Knock Knock! Cybercriminal at Your Doorstep   What’s the difference between the deep web and dark web? The dark web is part of the entire deep web and is hidden from regular browsing access. Most people confuse the deep web and the dark web as one entity. It is not. The deep web content includes anything hidden and restricted behind the security wall such as content which otherwise requires paywall or sign-in or blocked by the author. Content which cannot be easily accessible on regular internet such as medical records, membership websites, paid content are available on the deep web; hence it is also called Invisible Web.  No one really knows the total size of the internet, but the experts believe that the standard World Wide Web consists of only 4% internet, the deep web consists of 90% and dark web consists of 6% of the entire internet.  ALSO READ: Technology has changed the way we work amid the COVID-19 crisis: A look at in-demand technologies Image: Kalkine     Also read: It happens again, NZX being bullied by Cyber-attackers- Down for the fourth day   What kind of risk companies face due to the dark web?  The Into the Web of Profit report listed below threats various organisations around the world are facing, especially the ones who have weak or insufficient cybersecurity measures.   Malware attacks Distributed denial of service (DDoS) attacks Botnets Trojan, keyloggers, exploits  Espionage  Credentials access  Phishing  Refunds Customer data Operational data Financial data Intellectual property/ trade secrets    Also read: Cybersecurity and the Requirement of a Resilient Environment in Australia  Are there advantages and disadvantages to the dark web?  The dark web provides complete anonymity, the users get complete privacy to perform any activity, be it illegal or legal. Many countries in the world still have authoritarian regimes offering no civil rights to their people. To such oppressed lot, the dark web provides an opportunity to access news, information, data and also express their views. The dark web is also a perfect place for law agencies to map criminal activities while being undercover. It is also easy to commit gruesome crimes through the dark web as it is complicated and lawless. Criminals can easily use the dark web to compromise someone's privacy, steal data or private information or even hire someone to commit murder.  Do internet users need to be concerned about the dark web?  The simple answer is no unless the user is using the dark web. Study says that most young people visit the dark web out of curiosity. They do not want to indulge in any criminal activity but want to see how the hidden and secret world of the dark web operates. And that is where the possibility of the electronic device IP address getting hacked by other criminals to perform their criminal activities lies.  The earliest use of darknet dates back to the year 2000. Freenet was created at the University of Edinburgh based on a student research paper. Ian Clark wrote the paper in 1999 on the possibility of such an encrypted internet base. Freenet was created to oppose censorship and provide a platform for free speech. The most powerful dark web is TOR, and it was created by the United States government to have a secure encrypted communication in case of emergency and complete disaster. Even today, many law agencies are secretly active inside the world of the dark web to gain access in the criminal world and stay one step ahead.

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