Debt Management Ratios (Leverage Ratios)
The extent to which a firm uses debt financing, or financial leverage, has three important implications:
By raising funds through debt, stockholders can maintain control of a firm while limiting their investment 2.
Creditors look to the equity, or owner-supplied funds, to provide a margin of safety, so the higher the proportion of the total capital that was provided by stockholders, the less the risk faced by creditors 3.
If the firm earns more on investments financed with borrowed funds than it pays in interest, the return on the owners’ capital is magnified, or “leveraged.
To understand better how financial leverage affects risk and return, consider the sample table below. Here we analyze two companies that are identical except for the way they are financed. Firm U (for “unleveraged”) has no debt, whereas Firm L (for “leveraged”) is financed with half equity and half debt that costs 15 percent. Both companies have $100 of assets and $100 of sales, and their expected operating income (also called earnings before interest and taxes, or EBIT) is $30. Thus both firms expect to earn $30, before taxes, on their assets. Of course, things could turn out badly, in which case EBIT would be lower. Thus, in the second column of the table, we show EBIT declining from $30 to $2.50 under bad conditions. Even though both companies’ assets produce the same expected EBIT, under normal conditions Firm L should provide its stockholders with a return on equity of 27 percent versus only 18 percent for Firm U. This difference is caused by Firm L’s use of debt, which “leverages up” its expected rate of return to stock-holders. There are two reasons for the leveraging effect: (1) Since interest is deductible, the use of debt lowers the tax bill and leaves more of the ﬁrm’s operating income available to its investors. (2) If operating income as a percentage of assets exceeds the interest rate on debt, as it generally does, then a...
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