Wednesday, April 28, 2010

Leverage ratios

Leverage has to do with a company's debt structure: the greater the component of long-term debt in the overall debt structure, the greater the financial leverage. The following measures help you determine whether your company's level of debt is appropriate and assess its ability to pay the interest on its debts.
  • Interest coverage. This measures a company's margin of safety: how many times over the company can make its interest payments.
    To calculate interest coverage, divide earnings before interest and taxes by the interest expense.
  • Debt to equity. This measure provides a description of how well the company is making use of borrowed money to enhance the return on owner's equity.
    To calculate the debt-to-equity ratio, divide total debt (long-term debt plus short-term debt plus current maturities) by total shareholders' equity.

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