1.2.4 Leverage

1.2.4 Leverage

Leverage is one of the most powerful concepts in finance. It can be measured in many different ways, but the most important thing is for you to develop the underlying intuition.

 

Leverage Ratios

As we saw, Leverage is about borrowing money to run a larger enterprise than your Equity would otherwise enable you to.  The right measure of Leverage again depends on your perspective.

Total Debt/Total Assets

This ratio measures the proportion of all Assets that are financed by Debt.

Long-term Debt/Capitalization

The denominator in this ratio is Capitalization – the combination of a company’s Debt and Equity. As we saw, there are two primary types of financing for a company, and we think about them differently – Debt has a fixed interest cost associated with it, while Equity holds a variable rate of return, along with ownership rights. This ratio tracks what proportion of a company’s financing comes from Debt. By excluding liabilities that are not Debt, we focus exclusively on sources of financing that are not part of a company’s operations.

Total Assets/Net Worth

As we saw, one of the best things about leverage is that it grants the ability to control more Assets than a company would otherwise have the right to control. This ratio tells us precisely how many more Assets a company can control than its own Equity Capital.  As a consequence, it also measures how returns are magnified through the use of leverage.

EBIT/Interest Expense

The three previous measures were constructed from balance sheets, but the critical question may be the degree to which a company can make its interest payments. This ratio measures a company’s ability to fund the interest payments from its operations [Earnings Before Interest and Taxes] and uses only data from the income statement.  As one example, a ratio of 1 indicates that a company is just able to make its interest payments with its current operations. A hybrid measure using elements from both the income statement and the balance sheet – Debt/EBITDA – is a way to combine information from the balance sheet and the income statement.

Which Ratio to Use?

Each leverage ratio answers a different question. Drag and drop the ratio to the question it answers.

ITEMS

CATEGORY

How many more assets do I control because of debt?
LONG-TERM DEBT / CAPITALIZATI-
ON
How much of my financing is debt?
TOTAL ASSETS / NET WORTH
How many of my assets were financed with debt?
TOTAL DEBT / TOTAL ASSETS
Can I make my debt payments?
EBIT / INTEREST EXPENSE

Result

Incorrect.

You have 2 items in the wrong category.

Alan Jones: Using Other People’s Money to Multiply Earnings

As a Private Equity Manager, Alan Jones uses leverage to buy companies.  Here he talks about the magnifying power of using Debt to increase Profits, as well as its corresponding dangers. (at 0:52, he misspeaks, saying $20 when he means $30)

 

Let’s Look at Some Real-World Examples

Over the last two decades, pharmaceutical companies have been slowly increasing their leverage.  For example, in 2001, Merck had a Debt to Capitalization ratio of 0.30; Pfizer had a Debt to Capitalization ratio of 0.33. In 2015, Merck’s Debt to Capitalization was 0.37; Pfizer’s was 0.38. What do you think is going on in this industry that is causing this shift?

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Alan Jones: Leverage and Finance

Leverage can be a double-edged sword. Alan Jones, whose business revolves around using leverage, is constantly thinking about the risks and rewards of leverage.

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