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.
In effect, as the distance ‘b’ gets longer, it becomes easier to lift M1.
This principle works with finances too. How so?
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.
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.
Wow, this seems relatively easy to understand, why not do this a lot more and make a lot of profits for the shareholder’s?
The problem is RISK. 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.
There are solutions to reduce risk associated with debt, they include:
- Appropriate Leverage
- Incremental Leverage
- Debt Disposal Processes (Sale of the asset to pay off the debt)
- Cooperative Agreements with Other Airlines
To measure this risk factor, an investor looks at the leverage ratios for risk exposure. Leverage ratios consist of:
- Debt Ratio
- Interest Coverage Ratio
- Debt to Equity
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.
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 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:
- Hospitality (Marriott Hotels) – 84.4%
- Utilities (Duke Energy) – 71.9%
- Transportation (Union Pacific) – 57.0%
- Retail (Walmart) – 60.5%
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.
Interest Coverage Ratio
This particular ratio brings into play a business concept with the acronym – EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization.
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.
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:
Interest Coverage Ratio = EBITDA
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:
EBITDA (2018 Fiscal Year Ending 01/31/18) = $30,966 Million = 14.22:1
Net Interest Paid $2,178 Million
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.
Simon Property Group is the 2nd largest market capitalization REIT 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%!
Notice the vast difference between a retail entity and a real estate company. This is a perfect example of why business ratios are not universal across all industries. As a user of ratios, be respectful of the industry standards and not some universally assumed norm.
Debt to Equity
The debt to equity ratio is really a variance of the debt ratio. Interestingly, if you know one of the ratios, you can easily calculate the other. Since the balance sheet is comprised of three major areas of assets, debt and equity; if you know two of the three, the third is simple addition/subtraction formula. Now with all three values, a user of ratios can easily calculate the debt ratio and the debt to equity ratio.
So why have both?
The answer is dependent upon the respective industry a business ratio user is evaluating. The debt to equity ratio is a very common evaluation tool used by banks. Banks are interested in knowing the risk factor for their respective position in a company’s finances. For a bank, an asset’s fair market value can decrease suddenly and the equity of the company absorbs that market fluctuation.
An historic example was the real estate downturn that occurred back in 2008. Real estate decreased in value 15 to 20% within months. Banks held loan positions whereby debt to equity of their customers were five or six to one. This meant, the bank’s collateral could no longer substitute as full payment in case of default. To fully understand this, let’s review a simple debt to equity ratio and the impact a market change has on the ratio.
Company XYZ owns a set of office buildings and rents out suites to long-term service based companies. XYZ’s balance sheet identifies the following summary presentation:
Fixed (Land & Buildings) 2,340,000
Total Assets $2,755,000
LIABILITIES AND EQUITY
Current Liabilities $28,000
Long-Term Bank Notes 2,150,000
Total Liabilities $2,178,000
Total Liabilities and Equity $2,755,000
As expected both halves of the balance sheet equal each other. The debt ratio is:
Debt to Equity Ratio = $2,178,000 = 3.77:1
The bank’s loan terms state that XYZ can not exceed a four to one ratio. If XYZ’s rents were to suddenly decrease due to market conditions, the company would experience financial losses that would in turn decrease equity. Let’s see what happens if in year X+1, the company experiences $125,000 in losses.
- Assets decrease by $137,000 to $2,618,000 (losses of $125,000 plus $12,000 of cash out for principal payments)
- Debt decreases by $12,000 due to principal paid on loans to $2,166,000
- Equity decreases by $125,000 due to losses to a new balance of $452,000
Debt to Equity Ratio = $2,166,000 = 4.79:1
See how quickly the ratio increases (which indicates poorer performance with this particular ratio) with a mere 22% decrease in equity? This same principle is true for bond holders and other creditors. A small market change can increase the risk position of debt holders. For the sophisticated investor, the key is to monitor the trend line for the debt to equity position. The greater the elastic position of the company’s product/services; the more important to protect against bankruptcy with lower debt to equity ratios. With many publicly traded companies, the CEO and the Board of Directors will pursue expansion of their company by issuing debt, thus increasing the debt ratio. Expansion of debt increases risk and this should negatively impact stock values.
In effect, debt is good to a certain point in the overall financial position of the company; remember leverage is designed to increase net profits. However, after a certain point, debt begins to drag down profits and especially affect profits if market conditions decline for the respective product/service the company renders. Every industry has an acceptable and reasonable zone of debt to equity ratios. Exceed the zone with higher ratios and the company’s risk exposure increases at a faster rate. If the debt to equity ratio is lower than average, then the company can expand operations by incurring more debt and in turn increase profits. Higher profits tend to support higher market values for the respective stock.
Application of Leverage Ratios
As a user of business ratios, you are wondering where they fit in in the overall scheme of building a good stock buy/sell model. The best answer is for you to understand the overall importance of leverage ratios. Within the five categories of ratios, leverage ratios are at best in the middle or tend towards less importance in overall value. Why?
First off, interest rates are relatively stable in comparison to their volatility back in the 70’s and 80’s. The more unpredictable market interest rates are, the more important leverage ratios become. Secondly, leverage ratios identify future issues. Most buying and selling decisions are based on past performance. As leverage increases, it is a key indicator that the future will have greater risk associated with market conditions if they wane. Those organizations where growth is expected, leverage ratios will be higher as the Board pushes growth through the expansion of debt. It is important to weigh where the company is in its life cycle and overall market position.
Finally, leverage ratios are more critical in the decision model for highly leveraged industries such as real estate, banking, or construction. As with all ratios, the user must look at the trend lines related to ratios to determine if the current period ratio is and indicator of good or poor performance. ACT ON KNOWLEDGE.