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LEVERAGE RATIOS

When a firm borrows money, it promises to make a series of interest payments and then to repay the amount that it has borrowed. If profits rise, the debtholders continue to receive a fixed interest payment, so that all the gains go to the shareholders. Of course, the reverse happens if profits fall. In this case shareholders bear all the pain. If times are sufficiently hard, a firm that has borrowed heavily may not be able to pay its debts. The firm is then bankrupt and shareholders lose their entire investment. Because debt increases returns to shareholders in good times and reduces them in bad times, it is said to create financial leverage. Leverage ratios measure how much financial leverage the firm has taken on.

Debt Ratio. Financial leverage is usually measured by the ratio of long-term debt to total long-term capital. Here ¬long-term debt ­ should nclude not just bonds or other borrowing, but also the value of long-term leases.3 Total long-term capital, sometimes called total capitalization, is the sum of long-term debt and shareholders` equity. Thus for Pepsi

Long-term debt ratio = long-term debt long-term debt + equity = 4,028 = .39 4,028 + 6,401

This means that 39 cents of every dollar of long-term capital is in the form of long-term debt. Another way to express leverage is in terms of the company`s debt-equity ratio: Debt-equity ratio = long-term debt = 4,028 = .63 equity 6,401

Notice that both these measures make use of book (that is, accounting) values rather than market values.4 The market value of the company finally determines whether the debtholders get their money back, so you would expect analysts to look at the face amount of the debt as a proportion of the total market value of debt and equity. One reason that they don`t do this is that market values are often not readily available. Does it matter much? Perhaps not; after all, the market value of the firm includes the value of intangible assets generated by research and development, advertising, staff training, and so on. These assets are not readily saleable and, if the company falls on hard times, the value of these assets may disappear altogether. Thus when banks demand that a borrower keep within a maximum debt ratio, they are usually content to define this debt ratio in terms of book values and to ignore the intangible assets that are not shown in the balance sheet. Notice also that these measures of leverage take account only of long-term debt. Managers sometimes also define debt to include all liabilities: Total debt ratio =

total liabilities

= 16,259 = .72 total assets 22,660

Therefore, Pepsi is financed 72 percent with debt, both long-term and short-term, and 28 percent with equity. We could also say that its ratio of total debt to equity is

16,259/6,401 = 2.54.

Managers sometimes refer loosely to a company`s debt ratio, but we have just seen that the debt ratio may be measured in several different ways. For example, Pepsi could be said to have a debt ratio of .39 (the long-term debt ratio) or .72 (the total debt ratio). There is a general point here. There are a variety of ways to define most financial ratios and there is no law stating how they should be defined. So be warned: don`t accept

a ratio at face value without understanding how it has been calculated.

Times Interest Earned Ratio. Another measure of financial leverage is the extent to which interest is covered by earnings. Banks prefer to lend to firms whose earnings are far in excess of interest payments. Therefore, analysts often calculate the ratio of earnings before interest and taxes (EBIT) to interest payments. For Pepsi, Times interest earned = EBIT = 2,581 = 8.0 interest payments 321

Pepsi`s profits would need to fall dramatically before they were insufficient to cover the interest payment.

The regular interest payment is a hurdle that companies must keep jumping if they are to avoid default. The times interest earned ratio (also called the interest cover ratio) measures how much clear air there is between hurdle and hurdler. However, it tells only part of the story. For example, it doesn`t tell us whether Pepsi is generating enough cash to repay its debt as it becomes due.

Cash Coverage Ratio. We have pointed out that depreciation is deducted when calculating the firm`s earnings, even though no cash goes out the door. Thus, rather than asking whether earnings are sufficient to cover interest payments, it might be more interesting to calculate the extent to which interest is covered by the cash flow from operations. This is measured by the cash coverage ratio. For Pepsi, Cash coverage ratio = EBIT + depreciation = 2,581 + 1,234 = 11.9 interest payments 321

3 A lease is a long-term rental agreement and therefore commits the firm to make regular rental payments.

4 In the case of leased assets accountants estimate the present value of the lease commitments. In the case of long-term debt they simply show the face value. This can sometimes be very different from present values.For example, the present value of low-coupon debt may be only a fraction of its face value.