In this video, learn how to use the debt ratio to quantify the level of a company's financial leverage.
- The benefit of financial leverage is that using borrowed money allows a company to be larger with the same level of shareholder investment. More borrowed money means more assets. More assets means more sales. More sales means more profits. Again, all with the same initial shareholder investment. So more leverage can mean a higher return on equity. This is great for the owners of the company. But too much leverage means that the possibility of loan default and possible bankruptcy is uncomfortably close. This is not great for the company's banks. Imagine three different scenarios involving a company with $100 in assets. Scenario one, low leverage. $99 in owner investment and $1 in borrowed money. Scenario two, middle leverage. $50 in owner investment and $50 in borrowed money. Scenario three, high leverage. $1 in owner investment and $99 in borrowed money. Now, let's say that something bad happens to the assets and they decline in value from 100 to $60. In scenario one with low leverage, there's virtually no risk of financial trouble such as a loan default. The assets are now only worth $60 but because the outstanding loan amount is just $1 there's still a large cushion for loan repayment. In scenario two with middle leverage there is now some risk of loan default. The assets are now only worth $60 and the outstanding loan amount is $50. Most of the equity cushion is gone and the lenders are now nervous about whether they will be fully repaid. And in scenario three with high leverage the ballgame is over. The company owes $99 to its lender and has assets worth only $60 to repay those loans. The company is bankrupt and now the lenders are going to be fighting each other in court to see who can claim the remaining assets because there isn't enough to repay everyone in full. So it is important for lenders, investors, and other interested parties to be able to assess the level of a company's leverage. Data from the balance sheet can be used for this exact purpose. The debt ratio is a measure of a company's leverage and is computed as total liabilities divided by total assets. The debt ratio summarizes the degree to which a company has borrowed the money needed to buy its assets compared to getting that money as an investment from owners. For Walmart for example as of January 31st, 2019, the 140 billion dollars of total liabilities relative to its 219 billion dollars in total assets means that the company borrowed about 64% of all the money it needed to buy its assets. Now, where did Walmart get the other 36%? Well, that 36% was invested by owners, either directly as paid in capital or over time through earnings that had been retained. Walmart's debt ratio of 64% tells you the extent to which Walmart has financed its business through borrowing. Now by comparison, Target has borrowed 73% of all the money it needed to buy its assets. Now, a general rule of thumb for large companies around the world is that debt ratios are usually between 50 and 60%. So we see that Target has substantially more leverage than average. If leverage gets too high, lenders become nervous about the borrower's ability to pay its loans. Business borrowing prudently used can increase the scale of a company's operations and therefore increase returns to the shareholders. But excess financial leverage increases the risk of bankruptcy or a costly loan default. The debt ratio, total liabilities divided by total assets, is an easy and intuitive measure of a company's financial leverage.
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