What are Financial Leverage Ratios and Why Are They Important?
The importance of leverage ratios and metrics can’t be overlooked when assessing a company’s financial capacity and risk. With these ratios, businesses can make informed decisions about their capital structure and overall money management strategy. This helps SaaS businesses maintain positive growth over time by evaluating their borrowing capacity in real terms and in relation to risk.
The Debt-to-Equity ratio is an important solvency indicator that reveals the proportion of a company’s funding that comes from debt compared to shareholders’ equity, and is commonly used in conjunction with the Asset-to-Equity ratio outlined below. To calculate this metric, both short and long-term liabilities are divided by the sum of all shareholder investments. The formula is Total Debt/Total Equity.
A higher debt-to-equity ratio measure often implies greater risk with regard to financing activities, mainly because there is more reliance placed upon borrowed money rather than capital raised through investors or owners themselves. Conversely, if the ratio is lower, it might signify less risk as additional capital has been raised from investors and founders.
It’s important to note that a higher debt-to-equity ratio may give current and potential investors less confidence in the potential of a SaaS business as it’s relying more on debt than on capital from other investors or the founder(s). Investors would need to determine if current investors and founders have contributed their maximum or if they have reservations about investing more cash into the SaaS business
In conjunction with the Debt-to-Asset ratio, the Asset-to-Equity ratio provides information on a business’s capital structure and insight into the degree to which assets have been paid for with shareholder’s equity. To calculate this ratio, you add both current and long-term assets and divide this by shareholder’s equity.
Using this ratio and the Debt-to-Equity Ratio, businesses and investors will have insight into how the business purchased its assets (debt, shareholder’s equity, and operations), and, ultimately, how leveraged it is and its risk level.
The Debt-to-Asset Ratio provides information on a business’s capital structure and insight into how leveraged the business is in relation to its assets. To calculate this ratio, you add both short and long-term debt and divide this by the sum of current and long-term assets.
A company that has a high debt-to-asset ratio has less flexibility to respond to changing market conditions and is very susceptible to interest rate increases, which we are currently seeing in the market. In environments of rising interest rates, businesses with high debt-to-asset ratios will spend more of their precious cashflows on interest payments – making it difficult to be profitable and limit long-term investments.
The Debt-to-EBITDA ratio is a financial metric that provides a snapshot of the amount of debt a business carries compared to the Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA). This ratio can be calculated by summing short and long-term debt and dividing by EBITDA.
This ratio helps lenders evaluate the creditworthiness of a business and helps determine the risk level associated with lending the business more debt. A lower Debt-to-EBITDA ratio indicates a company can service the debt payments, and may have room to take on more debt. A higher Debt-to-EBITDA ratio indicates a business may not be earning sufficient revenue from operations and may have trouble servicing its debt payments, which could result in insolvency.
Healthy Debt-to-EBITDA ratios will vary by industry. Established businesses and industries such as pipeline companies and utility companies will commonly have higher Debt-to-EBITDA ratios and still be very healthy as their revenue streams are more certain and often regulated. Start-ups will also commonly have high Debt-to-EBITDA ratios until they are able to grow the business and generate more revenue and EBITDA.
Interest Coverage Ratio
The Interest Coverage Ratio, also known as the Times Interest Earned Ratio, is a financial metric used to determine the capability of a company to pay its debt obligations through its operational earnings. To calculate this figure, Earnings Before Interest and Taxes (EBIT) is divided by the incurred interest expenses.
A high interest Coverage Ratio denotes that an organization has enough operating profits to pay off its debt-carrying costs, such as interest, and is well positioned to pay off its outstanding debt obligations. Conversely, if it’s low, it might be hard for the business to fulfill its debt-carrying costs and payments as there isn’t sufficient profit generated from operations. By monitoring the Interest Coverage Ratio, businesses can gauge if their existing capital structure is too heavily debt-weighted or if they have room to take on more debt.
With the Fed Rate at a 23-year high of 5.25% to 5.50% as the U.S. Federal Reserve tries to reduce inflationary pressures, interest expenses are now at levels not since before the financial crisis. With that, businesses are actively looking at rebalancing their capital structures to reduce their exposure to higher interest rates.
Fixed Charge Coverage Ratio
The Fixed Charge Coverage Ratio is similar to the Interest Coverage Ratio; however, in addition to considering interest expenses, the Fixed Charge Coverage Ratio also includes other fixed expenses such as rent, lease, and other debt payments. To calculate the Fixed Charge Coverage Ratio, Earnings Before Interest and Taxes (EBIT) is divided by all Fixed Charges.
It’s important to note that these fixed charges are commonly for things a business needs to operate, such as renting a retail location or leasing equipment. If a business cannot meet these financial obligations for these items and can no longer use them, they would struggle to operate and are at risk of closing.
Leverage ratios and metrics are important indicators when assessing a company’s financial capacity and risk. These ratios will show if a business’s capital structure is more heavily weighted towards debt or equity. With this information in hand, along with other specific business and industry information, businesses and investors can make informed financial and business decisions.
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