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Financial Leverage (Debt) Ratios

Debt-to-Equity Ratio. To assess the extent to which the firm is using borrowed money, we may use several different debt ratios. The debt-to-equity ratio is computed by simply dividing the total debt of the firm (including current liabilities) by its shareholders equity.

The ratio tells us that creditors are providing 81 cents of financing for each $1 being provided by shareholders. Creditors would generally like this ratio to be low. The lower the ratio, the higher the level of the firm's financing that is being provided by shareholders, and the larger the creditor cushion (margin of protection) in the event of shrinking asset values or outright losses. The median debt-to-equity ratio for the electrical appliance industry is 0.80. so Aldine is right in line with the industry. Presumably, it would not experience difficulty with creditors because of an excessive debt ratio.

Depending on the purpose for which the ratio is used, preferred stock is sometimes included as debt rather than as equity when debt ratios are calculated. Preferred stock represents a prior claim from the standpoint of the investors in common stock; consequently-, investors might include preferred stock as debt when analyzing a firm. The ratio of debt to equity will vary according to the nature of the business and the variability of cash flows.

An electric utility, with very stable cash flows, will usually have a higher debt-to-equity ratio than will a machine tool company, whose cash flows are far less stable. A comparison of the debt-to-equity ratio for a given company with those of similar firms gives us a general indication of the creditworthiness and financial risk of the firm.

This ratio serves a similar purpose to the debt-to-equity ratio. It highlights the relative importance of debt financing to the firm by showing the percentage of the firm's assets that is supported by debt financing. Thus 45 percent of the firm's assets are financed with debt (of various types), and the remaining 55 percent of the financing comes from shareholders equity. Theoretically, if the firm were liquidated right now, assets could be sold to net as little as 45 cents on the dollar before creditors would face a loss. Once again, this points out that the greater the percentage of financing provided by shareholders' equity, the larger the cushion of protection afforded the firm's creditors. In short, the higher the debt-to-total-assets ratio, the greater the financial risk; the lower this ratio, the lower the financial risk. In addition to the two previous debt ratios, we may wish to compute the following ratio, which deals with only the long-term capitalization of the firm.

Total capitalization where total capitalization represents all long-term debt and shareholders' equity. For Aldine, the most recent year-end long-term-debt-to-total-capitalization ratio is.

This measure tells us the relative importance of long-term debt to the capital structure (longterm financing) of the firm. Again, this ratio is in line with the median ratio of 0.24 for the industry. The debt ratios just computed have been based on accounting, book value, figures; it is sometimes useful to calculate these ratios using market values. In summary, debt ratios tell us the relative proportions of capital contribution by creditors and by owners.