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What You Should Know about Leverage Ratios and Penny Stocks

Leverage ratios are a category of ratios that demonstrate the mix of equity to debt for a penny stock company. Whether focusing on a company’s ability to make interest payments on loans or on its percentage of debt when compared to total assets, leverage ratios illustrate the stock’s ability to meet its long-term debt obligations.

Although leverage ratios are similar to liquidity ratios, leverage ratios focus on long-term debts rather than short-term obligations. As an investor, you want to know if a company can carry and finance the loans or mortgages it has taken on in the course of its operations, and you can get that information by using leverage ratios.

Debt ratio

The debt ratio is a very important tool for analyzing penny stocks. It measures how much debt a company has in relation to its total assets. Here it is:

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A company with $30 million in total assets but with $10 million in debt has a debt ratio of 33 percent ($10 million divided by $30 million = 33 percent).

With penny stocks, you want to ensure that the debt ratio is

  • Comparable to competitors: A debt ratio that’s approximately in line with the industry average shouldn’t concern investors. However, if the ratio is much higher than other players in the same space, that value may be a warning sign.

  • Shrinking: Debts have a way of getting out of hand, especially if the company isn’t paying the liability down over time. Any debt not being aggressively paid may be one that is too large.

  • Increasing only for business development: Debt can be useful, especially to open doors for increased growth opportunities. Any major increases in the debt ratio should be for business development.

  • Manageable: Can the company pay interest charges on the debt? Does it have any funds left over to pay the principal amounts?

Keeping these criteria in mind, you should be able to assess a company’s debt ratio. Specifically, you want to ensure that it is manageable and in line with the company’s prospects and goals, but not burdensome.

With the debt ratio, lower numbers are better.

Debt to equity

The debt to equity ratio compares how much capital has been contributed by creditors to how much has been contributed by shareholders. In other words, how much money does the company owe to creditors compared to how much it owes to shareholders? The ratio is as follows:

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For example, if shareholders invested $20 million since the initiation of the company, and the company currently has $10 million in debt, that’s a debt to equity ratio of 0.5 ($10 million divided by $20 million).

A weak debt-to-equity ratio, of around 1 or higher, could imply that the corporation may theoretically have difficulty paying its debts and obligations.

On the other hand, a low debt-to-equity ratio indicates that a company could create more profits by taking on more debt. It has the option of increasing its debt load to help the business grow.

Overall, debt-to-equity calculations aren’t significantly helpful when dealing with penny stocks. Although they do have some merit for comparison purposes, the cash flow and revenue growth rates have a far more dramatic effect on share prices among penny stocks.

With debt-to-equity ratios, lower numbers are better.

Interest coverage

The interest coverage ratio is a measure of how many times a company’s earnings (before interest and taxes) can pay the interest expenses on outstanding debt. The more times over a company can pay those specific debt-related obligations, the easier it can carry its debt load and the more likely lenders will be to extend it more credit.

Here’s the ratio:

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To generate the interest coverage ratio, divide a company’s net earnings into the sum total of all interest payments it is required to make to all sources for the next year. Generally, you will see high interest coverage values, perhaps as great as 20 or 50 or more, among those corporations that have their debt loads well under control.

Be wary of any penny stock that has an interest coverage ratio of less than 2, and be very worried if that value is falling or sits anywhere near 1.

With the interest coverage ratio, higher numbers are better.

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