LEVERAGE

Firms are financed by some combination o£ debt and equity. The right capital structure will depend on tax policy—high corporate rates favor debt, high personal tax rates favor equity—on bankruptcy costs, and on overall corporate risk. In particular, if we are concerned about bankruptcy possibilities, the long-run solvency or leverage of the firm may be important. There are two commonly used measures of leverage, the debt-to-assets ratio and the debt-equity ratio;

Debt-to-asset ratio = total liabilities / total assets

Debt-equity ratio = long-term debt / shareholder’s equity

As with liquidity measures, problems in measurement and interpretation also occur in leverage measures. The central problem is that assets and equity are typically measured in terms of the carrying (book) value in the firm’s financial statements. This figure, however, often has very little to do with the market value of the firm, or the value that creditors could receive were the firm liquidated.

Debt-to-equity ratios vary considerably across industries, in large measure due to other characteristics of the industry and its environment. A utility, for example, which is a stable business, can comfortably operate with a relatively high debt-equity ratio. A more cyclical business, like manufacturing of recreational vehicles, typically needs a lower D/E—a reminder that cross-industry comparisons of these ratios is typically not very helpful.

Often, analysts look at the debt-equity ratio to determine the ability of an organization to generate new funds from the capital market. An organization with considerable debt is often thought to have little new-financing capacity. Of course, the overall financing capacity of an organization probably has as much to do with the quality of the new product the organization wishes to pursue as with its financial structure. Nevertheless, given the threat of bankruptcy and the attendant costs, a very high debt-equity ratio may make future financing difficult. It has been argued, for example, that railroads in the 1970s found it hard to find funds for new investments in piggybacking, a large technical improvement in railroading, because the threat of bankruptcy from prior poor investments was so high.