Risk and Leveraging Ratio

Risk and Leveraging Ratios

Investor look at leveraging ratios to determine how deep a company is on debt to access the risk associated if were to invest in this company. Z score or bankruptcy index provide even better indicator to measure risk and prediction of bankruptcy in near future.

Compare the debt ratios of two companies, investors can determine which company uses greater debt in conduct of its business.

Bankruptcy Index or Z score

Bankruptcy index or Z score developed by Edward I. Altman is a formula used to predict changes of a company's going bankrupt. The Z-score becoming more accurate as a firm nears bankruptcy. Although the Z Score is not applicable to financial institutions such as banks and finance companies. In the US, the Z Score has successfully predicted bankruptcies. Up to one year prior to corporate failure, 95% of the firms were correctly classified. Up to two years prior to failure, accuracy fell but was still as high as 74%.

Bankruptcy index

=1.2*A1+1.4*A2+3.3*A3+0.6*A4+1.0*A5

A1 = (Working capital = Current assets minus Current Liabilities) divided by Total Assets

A2 = Retained earnings divided by Total Assets

A3 = EBIT (profit before tax) divided by Total Assets

A4 = (Market value of equity = Market Capital = Market Price per share *

Number of stocks) / Total Liability

A5 = Asset turnover equal to Sales divided by Total Assets

<= 1.81

This company is in serious financial

trouble.

1.81 <

<= 2.99

No short term worries BUT need to

monitor this index closely.

2.99 <

Financially strong company.

The remaining funds or assets owned by a company after bankruptcy are always distributed to creditors in a the following order:
1. Bankruptcy court fees and Taxes
2. Employee salary
3. Secured bond holders
4. un-secured bond holders and creditors
5. Subordinated debentures
6. Preferred Stockholders
7. Common Stockholders

Gearing or Leveraging

The higher the gearing or leverage of a company, the greater the sensitivity of its profit to variations in sales volume. In other words, the more debt a company bears, the more likely it is to fail when sales go down especially during the recession. Check the sector or industry standards for a company you are studying.

Gearing measures the extent to which assets are financed by debt.

Gearing or Leveraging = Total Assets / stockholders' equity

Long-term Debt to Stockholder's equity.

Long term debt to stockholder's equity measures the long-term component of the capital structure.

Long term debt to stockholder's equity = Long-term liabilities / stockholders' equity

Debt to Asset Ratio

Debt to asset ratio measures the extent to which borrowed funds have been used to finance the acquisition of assets.

Debt to asset ratio = Total liabilities or debt / Total Assets

Interest Coverage Ratio

Interest coverage ratio also known as Times Interest Earned, it indicates the ability of the company to meet its interest costs.

Interest coverage ratio = Operating Profit (= Profit before interest and taxes) / interest charges

Interest Coverage

Ratio

<= 1

This company needs to borrow money

or sell assets to pay its interest charges!

Interest coverage tell bondholder's whether a company could have problems to meet their interest payments and also provide investors an indication of the short-term financial health of the company.

Coverage of Fixed Charges

Coverage of fixed charges measure company's ability to meet all of its fixed-charge obligations.

Coverage of fixed charges = (Profit before interest and taxes + lease charges) / (interest charges + lease obligations)

Coverage of fixed

Charges

<= 1

This company needs to borrow money

or sell assets to pay its fixed charges!