Understanding Leverage Ratios in Bookkeeping - dummies

Understanding Leverage Ratios in Bookkeeping

By Stephen L. Nelson

Leverage ratios measure how much debt a firm carries and how easily a firm pays the interest expenses of carrying that debt. Leverage ratios are important for an obvious reason. Typically, a firm mostly financed with debt needs to continue to borrow in order to stay in business. What’s more, a firm that carries a lot of debt typically also spends a lot of money on interest expense. The heavy interest expense means that it’s especially important for such a firm to have adequate operating income. Operating income is the income available to pay interest and other profits. A firm with a lot of operating income, relative to its interest expense, doesn’t really have much of a problem paying the interest, and this is true even if operating income declines or decreases.

Debt ratio

The debt ratio simply shows the firm’s debt as a percentage of its capital structure. The term capital structure refers to the total liabilities and owner’s equity amount. A firm funds its assets with its capital. Therefore, the total assets always equal the total capital structure.

The formula for calculating the debt ratio is a simple one:

total debt/total assets

No guideline exists for debt ratio. Appropriate debt ratios vary by industry and by the size of the firm in an industry. In general, small firms that use QuickBooks probably want to show lower debt ratios than larger firms.

Debt equity ratio

A debt equity ratio compares a firm’s long-term debt with a stockholder’s equity or owner’s equity. Essentially, the debt equity ratio expresses a firm’s long-term debt as a percentage of its owner’s equity.

Stockholders equity is synonymous with owners equity and, in the case of a sole proprietorship, with a sole proprietor’s capital account.

The following is the formula used to calculate a debt equity ratio:

long-term debt/stockholder's equity

There isn’t really a guideline for a debt equity ratio. You simply compare your debt equity ratio with the debt equity ratios of other, similar-sized firms in your industry. As is the case with the debt ratio previously described, the less long-term debt you carry, the better.

Times interest earned ratio

The times interest earned ratio indicates how easily a firm pays interest expenses incurred on its debt. To calculate the times interest earned ratio, you need an income statement that shows both operating income and interest expense.

The following formula is used for calculating the times interest earned ratio:

operating income/interest expense

No standard guideline exists for the times interest earned ratio. Obviously, however, the times interest earned ratio should indicate that a firm can easily pay its interest expense. It would be sort of scary, if you think about it, for the operating income to only be a little bit greater than the firm’s interest expense. Such a situation would indicate that a modest drop in operating income would make paying interest expense impossible.

Fixed-charges coverage ratio

The fixed-charges coverage ratio resembles the times interest earned ratio. The fixed-charges coverage ratio calculates how easily a firm pays not only its interest expenses but also any principal payments on loans and any other obligations for which a firm is legally obligated to pay.

The fixed-charges coverage ratio uses the following formula:

income available for fixed charges/fixed charges

The other input needed to calculate the fixed-charges coverage ratio is the income available for these fixed charges. You start with the operating income and add to the operating income any fixed charges included in the income statement.

No guideline exists to specify what your fixed-charges coverage ratio should be. In fact, it is particularly difficult to get the information necessary to think about fixed-charge coverage ratios because fixed charges don’t clearly appear in the standard set of simple financial statements. One of the things that make financial statements so useful is that the fixed-charges information is usually disclosed in little footnotes that appear at the end of the financial statements.