Leverage refers to the ability to lift a heavier load using a fulcrum, a lever and a second lighter weight. The common image is a board on a triangular pivot point with a heavy weight (M1) on one end and a lighter weight (M2) on the other. As the lever shifts towards the lighter load it starts to lift the heavier weight.<\/span><\/p>\n In effect, as the distance ‘b’ gets longer, it becomes easier to lift M1.<\/span><\/p>\n This principle works with finances too. How so?<\/span><\/p>\n Well, in finance, leverage is the use of borrowed funds (M2) to increase the profits (M1) of the company. Simply put, the money is borrowed to purchase assets and then these assets are sold or utilized to generate profit. The core accepted principle is that the cost of the borrowed funds is less than the profits generated before the interest is paid. An example is appropriate here.<\/span><\/p>\n Airlines use leverage to increase their profits. They identify that there is indeed a consistent demand for additional flights to and from a particular destination. After some analysis, the airline determines that the revenue less the marginal costs of operating a plane will exceed the interest cost to buy that plane. Thus, sales less operating costs (including depreciation for the plane) will exceed the cost of interest on the debt to buy that plane. The result is additional profit to the bottom line. The airline is using financial leverage (borrowing money) to increase net profits.<\/span><\/p>\n Wow, this seems relatively easy to understand, why not do this a lot more and make a lot of profits for the shareholder’s?<\/span><\/p>\n The problem is RISK<\/span><\/strong><\/a>. Since debt is relatively long-term, bonds to buy planes have extended maturity dates, up to 20 years. There is a good possibility that sales via passenger tickets will decrease in the future related to that particular flight, i.e. that plane. If this happens, where will the cash come from to pay the interest? The airline is still indebted and must make the interest payments on that bond.<\/span><\/p>\n There are solutions to reduce risk associated with debt, they include:<\/span><\/p>\n To measure this risk factor, an investor looks at the leverage ratios for risk exposure. Leverage ratios consist of:<\/span><\/p>\n This section of the book explains these ratios in detail, how their respective formulas are utilized and the proper interpretation of the respective ratio. The following sections introduce the respective leverage ratios.<\/span><\/p>\n The debt ratio is a simple comparison of total debt to total assets. It is common for certain industries to have higher debt than other industries. For example, a real estate investment trust<\/span><\/strong><\/a> will carry debt of more than 70% of total assets. This makes sense, real estate is a long term investment, bonds are issued to buy the apartment complexes or commercial locations. Rents cover operating costs and the remaining amounts pay interest and debt service for the real estate. Other industries have lower ratios of debt. Retail has less than 65% of its assets covered by debt. Here are some guiding ratios based on the respective industry:<\/span><\/p>\n The debt ratio reflects all liabilities as a percentage of all assets. In this chapter, you will discover two subset ratios of current liabilities and long-term debt ratios to their respective asset groups. The overall ratio is the debt ratio, but it is of extreme importance to break this respective ratio into the two sub components and then evaluate comparative information based on the two sub ratios.<\/span><\/p>\n This particular ratio brings into play a business concept with the acronym – EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization.<\/span><\/p>\n Interest is customarily paid from the earnings of the company, as referred to as operational income. EBITDA is often mistaken as operational income. With most publicly traded companies, depreciation and amortization is deducted prior to the calculation of operational income. Interest and taxes are deducted after operational income to determine net profit.<\/span><\/p>\n Thus the formula requires the user to modify operational income, at least determine how it is derived to calculate earnings before interest, taxes, depreciation and amortization. The formula is as follows:<\/span><\/p>\n Interest Coverage Ratio = EBITDA<\/span><\/span><\/span> There is no universal interest coverage ratio that is acceptable. This is because each industry has its own set of dynamics. The more elastic the industry, the higher the ratio necessary to protect against economic volatility. As an example, retail industries require very high interest coverage ratios to reduce risk exposure related to consumer confidence. Walmart’s interest coverage ratio is:<\/span><\/p>\n EBITDA\u00a0 (2018 Fiscal Year Ending 01\/31\/18)<\/span> = $30,966 Million<\/span>\u00a0 =\u00a0 14.22:1<\/span> Whereas inelastic industries can have significantly lower ratios. A perfect example is real estate (relatively inelastic). It is customary to have high debt ratios thus interest payments are greater than other industries. Also, inelastic industries tend to have lower operational profits as a percentage of sales. Thus the EBITDA is lower per dollar of revenue and so when the numerator decreases, and the denominator increases, you end up with a significantly lower ratio than retail.<\/span><\/p>\n Simon Property Group is the 2nd largest market capitalization REIT<\/span><\/strong><\/a> in the world. It owns malls and premium outlet centers. Its earnings before interest, depreciation, amortization and income taxes (REIT’s are technically income tax free under the Internal Revenue Code, however they may be taxable in certain states for income taxes) in 2018 was $5,009,464,000; its interest expense was $1,282,454,000. Simon Property’s interest coverage ratio was 3.91:1. As an interesting side note, Simon Property Group’s debt ratio is 87%!<\/span><\/p>\n![\"Leverage](\"https:\/\/businessecon.org\/wp-content\/uploads\/Lever.png\")
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Leverage Ratios – Debt Ratio<\/span><\/strong><\/h2>\n
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Leverage Ratios – Interest Coverage Ratio<\/span><\/strong><\/h2>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Interest Paid<\/span><\/span><\/p>\n
\nNet Interest Paid\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$2,178 Million\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0<\/span><\/p>\n