"Leverage"
measures the extent to which debt is used to finance a business. Higher leverage results from greater
proportions of debt financing as opposed to equity financing, and greater risk
generally accompanies higher leverage.
The most basic measure of leverage is the Debt to Worth Ratio:
Debt to Worth = Total Liabilities
Net Equity
The debt to
worth ratio presents the relationship between capital contributed by lenders
and capital contributed by owners.
Higher debt to worth implies more leverage and, therefore, more risk or
potential for volatility. A lower ratio
implies that the business may have untapped borrowing capacity.
The debt to
worth of Smith Heating and Cooling, Inc. is $234 to 1. So, one might say that, for every dollar the
owners have contributed, the company has borrowed $234 to operate the business. This amount seems astronomical. The business is indeed highly leveraged, but
their debt to worth ratio is anomalous.
The ratio is not informative.
When equity
is very small or negative due to losses on the income statement, the ratio
loses its meaning. A deficit or near
zero equity position may be a problem itself, as losses have eroded the capital
that was originally contributed by the owners.
Other balance
sheet items may throw off the meaning of the debt to worth ratio as well. For example, heavily depreciated buildings
may cause an artificially high debt to worth if their market values are
significantly higher than their book values.
The existence
of intangible assets may have the opposite effect, by inflating equity with
items that have little or no real value.
A solution is to calculate “tangible net worth” by excluding the book
value of intangible assets. You may then
calculate a “Debt to Tangible Net Worth” ratio:
Debt to Tangible Net Worth = Total
Liabilities
Net
Equity-Net Intangible Assets
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