I use leverage ratios in several articles but many online stock
screeners only provide debt-to-equity ratios (D/E). The two are
linked and either can be used in some cases. Let's take a closer look
starting with a few definitions.
I'll define leverage as equal to total assets divided by total equity.
Debt-to-equity can be calculated several ways. The debt part might be
long-term debt or total debt. The equity part might be common
shareholder's equity or total shareholder's equity. I'm going to
define the debt-to-equity ratio as total debt divided by total equity.
The accounting talk might be a little intimidating, but stay with me.
In practice it's not that difficult. Let's look at a real world
example. I'm going to focus on Altria's balance sheet from September
30, 2008 as presented by yahoo.com.
Here it is, but keep in mind we're only focusing on a few entries.
Assets
Current Assets
Cash And Cash Equivalents 915,000
Net Receivables 52,000
Inventory 1,060,000
Other Current Assets 1,818,000
----------
Total Current Assets 3,845,000
Long Term Investments 9,673,000
Property Plant and Equipment 2,162,000
Goodwill 81,000
Intangible Assets 3,041,000
Other Assets 1,868,000
----------
Total Assets 20,670,000
Liabilities
Current Liabilities
Accounts Payable 6,189,000
Short/Current Long Term Debt 284,000
Total Current Liabilities 6,473,000
Long Term Debt 601,000
Other Liabilities 3,603,000
Deferred Long Term Liability Charges 5,815,000
----------
Total Liabilities 16,492,000
Stockholders' Equity
Common Stock 935,000
Retained Earnings 22,113,000
Treasury Stock -24,444,000
Capital Surplus 6,369,000
Other Stockholder Equity -795,000
-----------
Total Stockholder Equity 4,178,000
(All figures in $1000s)
For our purposes we are interested in 3 figures
Total Assets: 20,670,000 (The sum of all assets)
Total Debt: 16,492,000 (The sum of all liabilities)
Total Equity: 4,178,000 (The sum of all equity)
(Note: Total debt is equal to total liabilities.)
You might notice that total assets happens to be equal total debt plus
total equity. It's no coincidence and it's true of all firms. But
before exploring the consequences further, let's check out Altria's
ratios.
Leverage = Total Assets / Total Equity
= 20,670,000 / 4,178,000
= 4.947 (rounded off)
Debt/Equity = Total Debt / Total Equity
= 16,492,000 / 4,178,000
= 3.947 (rounded off)
Generally speaking, firms with lower leverage ratios and lower
debt-to-equity ratios are more stable because they have more equity
and less debt. Value investors often look for firms that are debt
light and have low ratios.
Let's explore the connection between leverage and debt-to-equity
ratios. They are connected because total assets equal total debt plus
total equity. I'm going to do a little algebra, but it's quick and
hopefully painless.
Leverage = Total Assets / Total Equity
but
Total Assets = Total Debt + Total Equity
so
Leverage = (Total Debt + Total Equity) / Total Equity
Leverage = Total Debt / Total Equity + 1
or
Leverage = Debt/Equity + 1
We can now double check our formula with Altria's ratios.
Debt/Equity = 3.947 (rounded off)
Leverage = 4.947 (rounded off)
It's fairly easy to convert debt-to-equity ratios to leverage ratios
provided they're calculated using total debt, total equity, and total
assets. If they aren't then there'll be some subtle differences.
Many investors following Graham's Simple Way want to use debt/equity
ratios instead of leverage which is fine. Graham's stuck with
leverage ratios of less than 2.
Leverage < 2
That's the same as,
Debt/Equity + 1 < 2
or
Debt/Equity < 1
Again, this result requires the use of total debt, total equity, and
total assets to calculate the ratios.
I hope this little tutorial on debt ratios wasn't too intense. But I
tend to get questions on the two ratios and I'd like to help out less
vocal readers who might be scratching their heads in silence.
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