Leverage — How is it measured?

There are a number of measures of leverage. Perhaps the easiest and most often cited measure is the debt-to- equity (D/E) ratio. It indicates the relative proportion of owner’s equity and debt used to finance a firm’s assets. The two numbers needed are taken straight from your feed company or grain elevator’s balance sheet and are calculated as:

Debt/Equity = Debt-to-equity ratio where:

Debt = all of the liabilities (short-term and long-term) the business has

Equity = Shareowner’s or owner’s equity (also known as net worth)

Examples:

Grain Elevator A:

Debt = $972,000

Equity = $1,000,023

D/E ratio = 972,000/1,000,023 = 0.972 or 0.972:1 almost a 1:1 ratio

Grain Elevator B:

Debt = $2,347,054

Equity = $1,096,578

D/E ratio = 2,347,054/1,096,578 = 2.14:1 or over a 2:1 ratio

In the above examples, Grain Elevator A is equally financed between debt and equity, while Grain Elevator B has twice as much debt as equity and is much more “highly leveraged.”

On your balance sheet, the formal definition is that debt plus equity equals assets, or as one of us states in our university Agribusiness Management class — “your firm’s assets are jointly owned — either by you (equity) or the bank (debt).” Financial leverage ratios provide an indication of the long-term solvency of the business. Unlike liquidity ratios — which are concerned with short-term assets and liabilities — financial leverage ratios measure the extent to which the company is using long-term debt. In addition to the D/E ratio discussed above, another measure is the debt to capital ratio, defined as total debt divided by total assets:

Debt ratio = Total debt/Total assets

This measure tells whether a company is more prone to using debt financing or equity financing. Using the same numbers from our example above:

Grain Elevator A:

Debt = $972,000

Assets = (Debt + Equity) = $972,000 + $1,000,023 = 1,972,023

Debt ratio = 972,000/1,972,023 = 0.49

Grain Elevator B:

Debt = $2,347,054

Assets = (Debt + Equity) = 2,347,054 + 1,096,578 = 3,443,632

Debt ratio = 2,347,054/3,443,632 = 0.68

In these examples, Grain Elevator B is utilizing more debt financing, as 68 percent of its total assets are comprised of debt.

Leverage — Guidelines and Ranges

The range of what can be considered a “normal” debt-to-equity ratio can vary by industry. Some industries use more operating capital because they need to buy more materials to produce their products or services. Construction companies, for example, must purchase a lot of building materials, and they usually carry the cost of these materials via debt, until the finished product is sold. As a result, the debt-to-equity ratio in this industry can vary from 1.3 to 2.4 on the high end (with higher leverage given by a larger number — and anything over 1 indicating that the lender has a bigger stake in the firm than the owners do).

In contrast, a company in the services industry — such as an advertising agency or consulting company — does not have to buy much in the way of materials. These companies rely on their human “capital” and will have a lower D/E ratio, which might be in the 0.65 to 0.8 range. Some average debt-to-equity ratios by industry might be: Agriculture: 1.33; Mining: 0.48; Retail Hardware: 1.30; Automobile Retailing: 2.61; Restaurants: 1.24. The debt-to-equity ratio for cooperative grain elevators in the Pacific Northwest averaged 0.455 in a recent study conducted by Washington State University. As mentioned above — if a firm’s liabilities exceed the firm’s net worth, then creditors have more at stake than the owners, and the firm’s D/E ratio will exceed 1.0.

How can you make it work for you?

Borrowed money can be used to increase production volume, and thus sales and earnings. Since interest is a fixed cost (which can be written off against the firm’s revenue), a loan allows a firm to generate more earnings without a corresponding increase in equity capital — which for most corporations requires increased dividend payments (which cannot be written off against the earnings).