running a business. In addition, if the business earns a profit from the borrowed money, the profits for the business owners will increase significantly.
In financial analysis, the extent to which a company uses debt to finance its operations is called financial leverage. Financial leverage has two sides, on the one hand, financial leverage increases shareholder returns. On the other hand, financial leverage increases risk. Therefore, debt management is as important as asset management.
a. Financial Leverage
Financial leverage is a concept that refers to the level of debt and the impact of debt in the capital structure of a business. The financial leverage ratio is intended to determine the level of success of a business when using external capital to increase the efficiency of its own capital being used to generate profits.
Financial leverage (FL) | = | Rate of change in net income |
Rate of change of EBIT |
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Financial leverage is the use of fixed-cost financing to measure the sensitivity of after-tax profits - net income to equity - to changes in operating profits - EBIT. This sensitivity depends on the proportion of debt in total assets.
Assuming that the debt ratio, interest rate, and tax rate are constant, the rate of change in net income is equal to the rate of change in income taxes, and the rate of change in pretax profits. Thus, financial leverage is also determined as follows:
FL Financial Leverage= | Rate of change of profits before tax |
Rate of change of EBIT |
FL | = | EBIT | = | EBIT |
EBT | EBIT – 1 |
Or:
The level of financial leverage used by a business is reflected in the debt ratio. A business with a high debt ratio shows that the business has a high level of financial leverage and vice versa.
Enterprises use debt, on the one hand to compensate for the lack of capital in business operations, on the other hand hope to increase the rate of return on equity. The greater the financial leverage of an enterprise, the higher the rate of return on equity when the enterprise operates effectively. However, the use of financial leverage does not always bring positive effects to business owners, but it can also have negative effects on the enterprise when the enterprise does not use borrowed capital effectively. If the profit before tax and interest is less than the interest payable, it will decrease faster than the rate of return on equity, and if the enterprise is losing money, the loss will be even heavier.
b. Debt to equity ratio
Debt to Equity Ratio Equity | = | Total debt |
Equity |
This ratio assesses the company's debt usage and thereby also measures the company's financial autonomy.
This ratio shows the relationship between the enterprise's capital and borrowed capital. From the lender's perspective, this ratio should only fluctuate from 0 to less than 1. If it is equal to or greater than 1, the enterprise is too dependent on borrowed capital and thus the enterprise's risks are borne by the lender.
In addition, analysts can use the "Long-term debt to equity ratio" to see more clearly the level of regular debt financing of the business, thereby seeing the financial risks that the company has to bear.
c. Total debt to assets ratio.
The debt-to-assets ratio, also known as the debt ratio (D/A), measures the extent to which a company uses debt to finance its total assets. This means what percentage of a company's current total assets are financed by debt.
Debt to total assets ratio | = | Total debt |
Total assets |
The debt ratio is determined by dividing total debt by total assets. Total debt includes short-term debt and long-term debt payable.
This ratio is used to determine the obligations of the business owner to the creditors in contributing capital. Normally, creditors prefer a moderate debt to total assets ratio because the lower the ratio, the more secure the debt is in case the business goes bankrupt. Meanwhile, business owners prefer a high ratio because they want to increase profits quickly and want full control of the business. However, if the debt ratio is too high, the level of safety in business is worse, because just one debt due and not paid will easily cause the balance of payments to become unbalanced, the business is likely to fall into bankruptcy.
d. Long-term-debt-to-total-capitalization ratio
Long-term debt ratio | = | Long-term debt |
Fixed capital |
This ratio is determined by dividing long-term debt by total capitalization, which includes long-term debt plus equity.
This ratio shows what percentage of the value of long-term debt is compared to the total value of long-term capital that the business uses to operate.
e. Ability to pay interest or the number of times interest can be paid. ( Ability to pay interest)
In principle, the use of debt will generally generate profits for the enterprise, but for shareholders this is only beneficial when the profits generated by the enterprise are greater than the interest paid for the use of these debts. Otherwise, the enterprise will not be able to pay interest, causing direct losses to shareholders. Therefore, the ability to pay interest is an indicator that needs to be paid attention to.
The interest coverage ratio is determined by dividing earnings before interest and taxes (EBIT) by interest expense.
Interest Coverage Ratio= | Profit before tax and interest |
Interest expense |
Interest coverage ratio reflects the ability of a business to pay interest from its operating profits. This ratio shows the relationship between
between interest expenses and business profits, thereby helping to assess whether the business is able to pay interest.
The interest coverage ratio does not really reflect the entire debt liability of the enterprise because in addition to interest, the enterprise must also pay principal and other debts. Therefore, when analyzing finance, it is also necessary to pay attention to the enterprise's debt payment ability.
f. Ability to pay debt and interest.
The debt coverage ratio is determined by dividing the cost of goods sold plus depreciation and pretax profits by the principal and interest payable.
Debt coverage ratio= | (Gross Sales + Customer Service + EBIT) |
Principal + Interest Expense |
The debt coverage ratio measures a company's ability to pay principal and interest from sources such as revenue, depreciation, and pretax profits. Typically, principal is covered by revenue and depreciation, while pretax profits are used to pay interest. This ratio shows how much of each dollar of principal and interest can be used to pay off the company's debt.
The sources of capital that businesses usually have are equity capital and debt capital. These are two financial channels whose proportion of capital plays a very important role in the production and business of businesses. Businesses need to pay special attention to the management and control of debt capital. Financial leverage is one of the important indicators to determine the effectiveness of using debt capital.
1.2.2.3 Operational capacity ratio
Activity ratios are used to evaluate the efficiency of a company's use of assets. The capital of a company is used to invest in different types of assets such as fixed assets and current assets. Therefore, analysts are not only interested in measuring the efficiency of total assets but also pay attention to the efficiency of each component of the total assets of the company. Revenue indicators are mainly used in calculating these ratios to examine the operating capacity of the company.
a. Cash flow
Cash turnover indicates the number of times cash is turned over during the year. It is determined by dividing the revenue for the year by the average total cash and cash equivalents.
Revenue | ||
Cashflow | = | Average of money and assets cash equivalent |
Cash turnover ratio reflects the average number of times cash and equivalent assets are turned over in a period to generate revenue. To evaluate the business performance of an enterprise, relying only on the cash turnover ratio is not enough, so it is necessary to combine the analysis of a number of other indicators.
b. Inventory Turnover
To evaluate the efficiency of a company's inventory management, managers can use the inventory turnover ratio. This ratio can be measured by the number of inventory turnovers in a year or the number of days of inventory.
Inventory turnover is a very important indicator to evaluate the production and business activities of an enterprise. Inventory turnover is determined by the ratio between the annual revenue and the average value of inventory - reserves (raw materials, auxiliary materials, unfinished products, finished products).
(Reserve rotation)
Inventory Turnover= | Revenue |
Average inventory value |
Inventory turnover indicates how many times the average inventory is turned over in a period to generate revenue. If the inventory level is not managed effectively, the storage costs will increase, and this cost will be passed on to customers, causing the selling price to increase. If this ratio is too high, sales revenue will be lost. If this ratio is too low, the costs related to inventory will increase. The number of high or low inventory turnovers depends on the characteristics of the business industry. This ratio should only be compared with the average inventory turnover ratio of the industry or of companies in the same industry for evaluation. For example, companies that sell perishable or easily discounted goods have high inventory turnover.
c. Average collection period
In financial analysis, the average collection period is used to assess the ability to collect payments based on accounts receivable and average sales per day.
(ACP)
Average collection period= | Average receivables |
Revenue/360 |
Accounts receivable are sales invoices that have not been collected due to the business implementing credit sales, deferred payment policies, and unpaid advances, prepayments to sellers, etc. When customers pay all their outstanding invoices to the company, then the accounts receivable have turned over one cycle.
This ratio gives analysts and business managers insight into the quality of receivables and the company's debt collection efficiency.
The average collection period is high or low, depending largely on the credit policy of the enterprise such as credit sales, deferred payment. If the receivable turnover is low, the efficiency of capital use is poor because the enterprise's capital is occupied by other enterprises. On the contrary, if the receivable turnover is too high, it will reduce the competitiveness in the enterprise's business activities, leading to a decrease in revenue.
When analyzing this ratio, in addition to comparing between years, comparing with businesses in the same industry and comparing with the industry average ratio, businesses need to review each receivable to promptly detect overdue debts in order to have appropriate handling measures.
d. Asset Turnover
This ratio measures the efficiency of fixed asset utilization. Fixed asset utilization is determined by dividing revenue by fixed assets.
Fixed Assets (FATO)
Performance= | Revenue |
Fixed assets |
This indicator shows how much revenue one dong of fixed assets generates in a year.
e. Total asset turnover
This ratio is also known as total asset turnover. It is measured as the ratio of sales to total assets.
total assets (TATO)
Performance= | Revenue |
Total assets |
This ratio shows how much revenue is generated per dollar of assets. This ratio is used to evaluate the operating efficiency of total assets. If this ratio is high, it shows that the company can generate more revenue per dollar of invested capital.
1.2.2.4 Profitability Ratios
If the above groups of ratios reflect the effectiveness of each separate activity of the enterprise, the profitability ratio most comprehensively reflects the production - business efficiency and the enterprise management efficiency.
Profitability ratio measures the income of the enterprise with other factors that generate profit such as revenue, total assets, and equity. The profitability of the enterprise has a great influence on the ability to pay debt and interest. Therefore, when lending, the lender also needs to pay attention to analyzing the profitability of the enterprise.
Depending on the goal of analyzing the profitability of a business, analysts can use the following ratios:
a. Return on Investment
Return on capital measures the ability to generate profit on a unit of capital invested in a business, regardless of the sources of investment capital, and how much profit a unit of capital invested in a business generates for the economy.
This ratio is determined by taking earnings before interest and taxes and dividing it by average total capital.
(ROD)
Rate of return= | Earnings before interest and tax |
Average total capital |
Return on capital reflects the most objective efficiency of capital use and can be used to compare the profitability of investment capital of different enterprises.
b. Product sales revenue
This is the first indicator reflecting the business's performance and the two factors are closely related to each other. Revenue shows the role and position of the business in the market. Profit shows the quality and final efficiency of the business.
Product sales revenue | = | Profit after tax |
Revenue |
This ratio is determined by dividing after-tax income (profit after tax) by revenue.
The above ratio reflects the amount of profit after tax in one hundred dollars of revenue. This ratio measures the ability to make profit compared to revenue.
c. Return on equity (ROE): ROE Return on equity (ROE) is
The indicator reflects how much profit one dong of owner's investment in the company brings to the owner after deducting corporate income tax.
ROE | = | Profit after tax |
Equity |
This ratio is determined by dividing profit after tax by equity.
This ratio reflects the profitability of equity and is of particular interest to investors when they decide to invest in a business. Increasing the level of equity profit is the most important goal in the financial management of a business.
The effect of financial leverage on ROE
The profit that is earned by common shareholders is the profit that is earned from the company's business operations after covering the costs of raising capital such as the cost of debt (interest minus tax shield) and dividends paid to preferred shareholders. If the rate of return on total assets of the company is greater than the average after-tax cost of debt and the cost of preferred equity, the remaining difference will be enjoyed by common shareholders, resulting in ROE > ROA. Conversely, if the rate of return