Calculate Financial Leverage

In the previous article “Debt Equity Ratio and Debt Ratio”, we discussed the relationships between debt-to-equity ratio and debt ratio and showed the formula to derive either one from the other. In this article, we are going to discuss the financial leverage and show the relationships between financial leverage and debt-to-equity ratio and use Starbucks as the example to show the calculation of financial leverage from its income and balance sheet statement

What is Financial Leverage

Financial leverage is a ratio to measure the multiply effect on the original return. Although there are many techniques to achieve this, the simplest way for a company to leverage its equity is by borrowing money. Let’s use Starbucks’ financial statement to explain how Starbucks multiplies its return by borrowing money. Here is the link to Starbucks’ income statement and balance sheet statement.

Calculate Financial Leverage from Financial Report

From its income statement, Starbucks has net income $1245.7M in 2011. Also from its balance sheet, Starbucks’ averaged Total Assets during 2010-2011 is $6873.15M ((7360.4+6385.9)/2). That gives Starbucks’ Return on Assets (ROA) 18.12% (1245.7/6873.15). However, from the investor’s point of view, the return is higher than 18.12%. When we purchase Starbucks’ stock, we become the stake holders of the company. That means we own a portion of the company’s equity depends on how many shares we have. In that sense, the actual return from the investor’s point of view should be calculated by using averaged Total Equity instead of averaged Total Assets.
From its balance sheet, Starbucks’ averaged Total Equity during 2010-2011 is $4029.8M ((4384.9+3674.7)/2). So the Return on Equity (ROE) for Starbucks is 30.91% ($1245.7M/$4029.8M), which is 1.71 x 18.12%. Because part of Starbucks’ assets is debts, it is able to generate higher return and we call the ratio 1.71 financial leverage

Calculate Financial Leverage from Debt Equity Ratio

From the above example, we can see that financial leverage = Return on Equity / Return on Assets, while Return on Equity = Net income / Averaged Total Equity, and Return on Assets = Net Income / Averaged Total Assets
=> Financial Leverage= Averaged Total Assets / Averaged Total Equity
= (Averaged Total Liabilities + Averaged Total Equity) / Averaged Total Equity
=> Financial Leverage = Debt-to-Equity Ratio + 1
Take Starbucks for example, it has averaged total liabilities $2843.35M ((2975.5+2711.2)/2) and averaged total equity $4029.8M. That gives us debt-to-equity ratio = 0.71. Because financial leverage ratio is also = Debt-to-Equity Ratio + 1, we get the same financial ratio 1.71

Commentary

The formula we derived above is convenient because Debt-to-Equity ratio is a common ratio that we can get. Simply add 1 to the debt-to-equity ratio then we can get the financial leverage ratio

Debt Equity Ratio and Debt Ratio

In the previous article, we briefly talked about debt equity ratio and mentioned that debt equity ratio is related to the company’s financial leverage. However, many investors confuse debt equity ratio and debt ratio. Actually debt equity ratio is not the same as debt ratio but either one can be derived by the other one. In this article, we are going to explain the relationship between debt equity ratio and debt ratio

Debt Equity Ratio

Debt equity ratio is calculated by dividing a company’s total liabilities by stockholder’s equity:
Debt Equity Ratio = Total Liabilities / Total Equity (Eq. 1)
It gives investors an idea how a company has been aggressively borrowing money to grow its business. High debt equity ratio indicates that the company is aggressively expanding its business by using a large portion of capital that is not its own. If the incremental profit generated by expanding is higher than the cost of interests, the company is generating more profit compared to the scenario had company not borrowed the money. On the other hand, the company could generate larger than expected loss if the result doesn’t go well.

Debt Ratio

Similar to debt equity ratio, debt ratio is calculated by dividing a company’s total liabilities by its total assets, which is a company’s total liabilities plus total stockholder’s equity
Debt Ratio = Total Liabilities / Total Assets (Eq. 2)
From Eq. 1 and Eq. 2, we can derive:
Debt Ratio = Debt Equity Ratio / (1+Debt Equity Ratio) (Eq. 3)
Note from Eq. 3 we can see that Debt ratio always greater than or equal to 1 since debt equity ratio can’t be less than 0
Based on the equation above, we can easily calculate the debt ratio based on debt equity ratio.

Application

The concept of debt ratio can not only apply to individual company but also can apply to industry or sector level. If we use Stock Market Browser to investigate the debt equity ratio of 9 sectors, we see the sector Industrial Goods has the highest debt to equity ratio while Basic Material has the lowest debt to equity ratio.
 


 

We can apply Eq. 3 to calculate these two sectors’ debt ratio:
For sector industrial goods, its debt ratio = = 65.64%
For sector Basic Materials, its debt ratio = = 27.54%

Commentary

Although debt equity ratio is used more frequently, both debt equity ratio and debt ratio give investors the same information. However, debt equity ratio is more convenient when calculating a company’s financial leverage, which we will discuss in the next article

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Stock Market Browser V 1.18 Available Now

We are pleased to announce that the Stock Market Browser (SMB) version 1.18 is released! ! If you have purchased this software before, you can upgrade to the latest version with no charge at all
 

What’s New in Version 1.23

“Zoom in” option in Popup Menu

The Zoom in option in Popup Menu allows you to access all industries available from the sector you choose or allows you to access all companies available from the industry you choose. One of the wildly used situations would be to access all companies available from the industry you are interested in from “All Industries”. Suppose you are interested in getting a list of companies in “Business Equipment” that matches your screening criteria, you can simply highlight “Business Equipment”, right click mouse button, and then choose option “Zoom in”, just like sample screenshot below.



Following is the sample screenshot after choosing “Zoom in” Option:



The table will show the list of companies in “Business Equipment” industries. Also the Browser Window will highlight the industry you choose to give you an idea which sector this industry belong to (see red box above)

Add Online Resources Tab in Information Window

The Online Resources tab in information window allows you to access popular website to get more information about a particular company that you are interested in. Following is a sample screenshot



If you are interested in Xerox Corp. (XRX) in Business Equipment industry, you can double click XRX, Stock Market Brower will provide you basic company information such as its profile, news, and chart. If you want to get to know more about Xerox, simply choose Online Resources table and choose the website you prefer to have access. Currently you can choose the website among Yahoo Finance, Google Finance, MSN Money, and Stock Market Watch.
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Debt to Equity Ratio in Stock Market Browser

Stock Market Browser is a tool that can give you a quick snapshot of the total stock market from sector down to individual stock. One of the financial ratios it provides to you is Debt to Equity ratio. However, the meaning of Debt to Equity ratio in Stock Market Browser is different from the traditional meaning of Debt to Equity ratio. In this article, we are going to use Caterpillar’s most recent balance sheet provided by Yahoo Finance to show the calculation of Debt to Equity ratio in Stock Market Browser and compare the number from traditional Debt to Equity ratio. Following is Caterpillar’s quarterly balance sheet from Yahoo Finance:

Traditional Meaning of Debt to Equity Ratio

Normally, Debt to Equity Ratio is defined a company’s total liabilities divided by a company’s averaged shareholders’ equity

From Caterpillar’s balance sheet of most recent quarter, it has total liabilities 68.09B and averaged total shareholders’ equity (12.883B + 14.162B)/2 = 13.52B. Based on the formula above, its debt to equity ratio would be 68.09 / 13.52 = 5.04
However, this number is different from the number provided by Stock Market Browser:



You can find out Caterpillar (CAT) under sector Conglomerate and industry Conglomerate.
As of 04/02/2012, Debt to Equity ratio provided by Stock Market Browser is 258

Derive Debt to Equity Ratio in Stock Market Browser

First of all, the unit of this ratio is 100%. That means 258 is actually 258%. So how Stock Market Browser derives 2.58?
Instead of using total liability to represent total debt, Stock Market Browser only use item “Long Term Debt” and “Short/Current Long Term Debt” to represent total debt. In other words, it only considers total long term debt as real debt.
Based on Caterpillar’s balance sheet of most recent quarter, it has short/current long term debt 9.648B and long term debt 24.944B. The Debt to Equity Ratio would be (9.648+24.944)/13.52 = 2.58, which is 258%
 

Conclusion

In the traditional definition, the company’s total liabilities is used to represent the total debt, but Stock Market Browser only uses total long term debt, which is the portion of liabilities that accrues the most of interest. Because it only uses the portion of liabilities that accrues the most of interest, the ratio can give investors a better measurement in terms of financial leverage and risk.