Leverage Ratios: Howe Soundly is the Company Financed? The leverage ratio is the third basic type of financial ratio. There are a number of balance sheet measures of financial leverage. The various leverage ratios measure the relationship of funds supplied by creditors to the funds supplied by owners. The use of borrowed funds by reasonably profitable companies will improve the return on equity. However, it increases the riskness of the business and the riskiness of the returns to the stockholders, and can result in financial distress if used in excessive amounts. The ratio of total assets divided by owners' equity is an indirect measure of leverage. A ratio, for example of 6 of assets for each $1 of owner's equity indicates that S6 of assets is financed by $1 of owners' equity and 5 of Bibilities cument is where to Mums Try is Corporate Finance any WILLIAM COFNOG Beacon Cunge introm For the LAVII u U Awing Company's Future Financial Beach 1. SciTronies ratio of total are divided by owners' equity increased decreased from_at year-end 2005 to __at year-end 2006 The same story of increasing financial leverage is told by dividing total liabilities by total assets. 2. At year end 2008, SciTronics' total liabilities were of its total assets, which compares within 2005 Lenders---especially long-term lenders-want reasonable assurance that the company will be able to repay the loan in the future. They are concerned with the relationship between a company's debt and its total economic value. This ratio is called the total debt ratio at market Total liabilities Total abilities + market value of the equity The market value of the equity is calculated by multiplying the number of shares of common stock outstanding times the market price per share. 3. The market value of SciTronics' equity was $175,000,000 at December 31, 2008 The total debt ratio at market A fourth ratio that relates the level of debt to economic value and performance is the times interest eamed ratio. This ratio relates earnings before interest and taxes a measure of profitability and of long-term viability to the interest expense-a measure of the level of debe Earnings before interest and taxes Interest expense 4. SciTronics' earnings before interest and taxes (operating income) were 5_ in 2008 and its interest charges were los times interest camed was times. This represented an improvement deterioration from the 2005 level of A fifth and final leverage ratio is the number of days of payables. This ratio measures the average number of days that the company is taking to pay its suppliers of raw materials and components. It is calculated by dividing annual purchases by 365 days to determine average purchases per day Annual purchases 365 days Accounts payable are then divided by average purchases per day: Accounts payable Average purchases per day to determine the number of days of purchases that are still unpaid. It is often difficult to determine the purchases of a firm. Instead, the income statement shows the cost of goods sold, a figure that includes not only raw materials but also labor and overhead. Thus, one can often gain only a rough idea as to whether a firm is becoming more or less dependent on its suppliers for finance. This can be done by tracking the pattern over time of accounts payable as a percent of cost of goods sold