Thursday, July 5, 2018

Leverage and Debt to Worth

"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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