Prudent leverage in a business can increase the return on equity. Learn how to measure a company’s degree of leverage three different ways, including debt ratio, debt to equity ratio, and asset to equity ratio.
- Sometimes shareholders, that is, owners in a company, are not able to provide all the money necessary to buy all the assets needed to fulfill the company's business objectives. In those instances, the company will need to borrow money. Owners, or the investors, leverage their investment in the company by borrowing money. That leverage will make the business larger with the same initial shareholder investment. So why borrow? Borrowing allows a business to have more funds available to buy more assets, and more assets generate more sales.
And more sales generally means more net income. If a company can borrow money at, say, 4%, and invest in projects that earn 10%, who gets that extra 6%? That accrues to shareholders. With more leverage, that is, more borrowing, a company's return to shareholders can be higher, even with the same amount of shareholder investment. So how do you measure a company's degree of leverage? By now, you're probably familiar with various financial statement ratios.
Profit margin, current ratio, return on equity, to name a few. These are standard ratios with agreed-upon means of computing the ratios. With leverage, that's not the case. When someone quotes a measure of a company's leverage, you'll need to ask how that measure was computed. Comparing one measure of leverage with another computed using different types of numbers is meaningless. Let's review three common measures of a company's degree of leverage. To do this, let's use two department stores, Nordstrom and Dillard's.
The first leverage ratio we'll look at is what's called the debt ratio. This ratio is computed by simply dividing a company's liabilities by its assets. We see for Nordstrom their debt ratio is 89%. For Dillard's, about 54%. What does that 89% mean? Of all the money that Nordstrom needed to buy its assets, it borrowed about 89%. Dillard's borrowed about 54%. The rule of thumb is that for large companies, a debt ratio is usually between 50 and 60%, so when I see that 54% debt ratio for Dillard's, I think, fine, they're normal, they're leveraged.
They've borrowed about the same amount as most companies borrow. When I see that debt ratio of Nordstrom, on the other hand, of 89%, I have some questions. I'd like the chief financial offer, the CFO for Nordstrom, to tell me, what was the business decision that made you have so much leverage? Why do you have 89% leverage when most of your competitors have substantially lower leverage? Now, another measure of leverage is called the debt to equity ratio. Total liabilities divided by total shareholder investment.
We see that number for Nordstrom is almost eight. For Dillard's, it's closer to one. Nordstrom has a lot more debt relative to its equity than Dillard's, a lot more. Now, note that with both of these ratios, the conclusion is the same, but the numbers are different. Nordstrom is much more leveraged than is Dillard's, but you cannot compare the results of Nordstrom's debt ratio to Dillard's debt to equity ratio. All right, here's one last leverage ratio, the asset to equity ratio.
This ratio is computed by dividing total assets by total shareholders' equity. The higher the number, the higher the relative amount of debt held by a company. We see again that Nordstrom has much more debt than does Dillard's. Now, at this point, we need to stop, because I'm sure you're wondering, now, wait a second, what is this measure of leverage? We just saw the debt ratio, we saw the debt to equity ratio, and the asset to equity ratio. Which is the one? How are they different? Well, it turns out they're all related to the same underlying data.
Now, let me show you a simple numeric example to illustrate the point. We've got a basic company. Investors invest a dollar. They then go out and borrow a dollar and with those two dollars they can now buy two dollars of assets. Two dollars of assets coming from one dollar of borrowing, a liability, and one dollar of owner investment. Let's now compute three different measures of leverage using the same common set of data. The debt ratio, one dollar of liabilities divided by two dollars of assets, equals 50%.
Half of the financing has come through borrowing. The debt to equity ratio, total liabilities divided by total equity, is one. It's one to one. We have exactly as much borrowing as we do shareholder investment. The asset to equity ratio is two. Total assets is two, shareholder investment is one. We have twice as many assets as we could buy with our own invested money. That means we had to leverage our investment. You see that there are three different measures of the same underlying leverage.
Why do we have three? Well, it's just a matter of taste. People use different ratios, but they all reflect the same thing. So how do we know which one to use? Well, the way to know is to ask the person on the other side of the table, which leverage ratio are you using? For example, somebody tells you the temperature is 22 degrees, is that hot or cold? Well, it depends on the measure you're using. Are you using the Fahrenheit scale? Then 22 degrees means it's cold, it's below freezing. You better have a coat on.
Are you using the Celsius scale? 22 degrees, it's comfortable, room temperature. Are you using the Kelvin scale? Well, then it's almost as cold, in fact, a little colder, than it is on Pluto. The same number, 22, means a different thing depending on what scale you're using. So you can see that a leverage ratio of .5, what does that mean? It all depends on the scale. So when you're talking with somebody and they say the leverage ratio is .5, you need to stop them right there and say wait, are you talking about the debt ratio, the debt to equity ratio, or the asset to equity ratio? Leverage is an important component of increasing a company's return on equity.
There are benefits to leverage. More leverage means more assets, more assets, more sales. More sales, more income with that same initial owner investment. So the benefit of leverage is that we can increase the size of our business and increase our profits by using somebody else's money. That's the benefit of leverage. Prudent leverage in a business can increase the return on equity, but leverage has to be used very carefully.
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