Financial
Leverage
Example

Home Page

Back to
NoteBook
Summary

Download
Demo

Nine ratios describe Leverage. They all are an indication of how a firm gets its operating funds..

1. Collection Period is defined as (Collection Period = Accounts Receivable / Sales X 365). It is measured in days. If the collection period is in excess of 40 days for Net30 terms it signals slow-turning receivables and hence dependence on other sources for operating funds.
2. Sales to Inventory is defined as (Sales to Inventory = Net Sales / Inventory) and measures how many times inventory is turned. While there is no published standard here, the higher this turnover the more readily operating funds will be coming from sales rather than say debt.
3. Assets to Sales is defined as (Assets to Sales = Total Assets / Net Sales). The lower this ratio the better a firm is at utilizing its assets.
4. Sales to Net Working Capital is defined as (Sales to Net Working Capital = Net Sales / Net Working Capital). This ratio is highly variable by industry, however a recent industrial composite is 8 to 1.
5. Accounts Payable to Sales is defined as (Accounts Payable to Sales = Accounts Payable / Net Sales). This ratio measures payments to suppliers. Lower is better than higher inasmuch as a firm does a good job of managng its payables.
6. Debt to Equity is defined as (Debt to Equity = Total Liabilities / Equity) also known as Debt to Net Worth. It measures the amount of long term protection available to creditors, stockholders or any other entity able to assess a claim against a firm. When this ratio moves beyond 3:1, the firm is highly leveraged.
7. Current Debt to Equity it defined as (Current Debt to Equity = Current Liabilities / Equity). It measures the amount of immediate protection available to creditors, stockholders or any other entity able to assess a claim against a company. A ratio over 1 could signal serious trouble for most industries.
8. Interest Coverage is also known as Times-Interest-Earned Ratio and is defined as (Interest Coverage = Pretax Income + Interest Expense / Interest Expense). This ratio calculates the number of times a firms interest is covered by earnings. It is best if this this ratio is over 3.
9. Debt Services is defined as (Debt Services = Pretax Income + Interest Expense + Depreciation / Interest Expense + Principle Due in Next Year). It measures to what extent debt services are covered. A ration in the neighborhood of  2 is acceptable. Highger than 2 is better than lower.