PLEASE NOTE: the following is an excerpt from "20 Competitive Metrics Every Business Needs to Know," which is now available as a free download here.
Performance Metric: LEVERAGE
Definition: A MEASUREMENT OF HOW A COMPANY USES DEBT TO FURTHER ITS OPERATIONS
Importance: Companies use debt to acquire assets in the hope that the income generated from those assets will be greater than the cost to service that debt over time. In most cases, the greater the debt the greater the risk because a company that is highly leveraged is more likely to go bankrupt than one that isn't. On the other hand, a company that has very low levels of debt may not taking advantage of the growth opportunities that additional leverage may offer.
Key metrics: Because "healthy" levels of debt vary by industry and by company size, analysts use leverage ratios to put debt in perspective:
- DEBT RATIO: total liabilities ÷ total assets
- DEBT-TO-EQUITY RATIO: total liabilities ÷ equity
Insight: Trends — how leverage ratios change over time — can be particularly informative because they indicate the degree to which a company is choosing or being forced to finance itself through creditors instead of through its own operations, which may suggest sales, marketing, product or management issues.
Goal: GOLDILOCKS ZONE
Links:
DEBT FUNDAMENTALS BY INDUSTRY (NYU)
WHY DO DEBT TO EQUITY RATIOS VARY FROM INDUSTRY TO INDUSTRY?
ANALYZING YOUR FINANCIAL RATIOS
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