Finance Risk Metrics
For companies and banks alike, leverage ratios are invaluable indicators of the amount of credit extended to a firm, especially if that loan is used to finance expansion activities. It is also an important metric for financial analysts and traders to consider because it is an evaluation of how easy a firm is able to fulfill future financial obligations. The concept of leverage is fairly simple; it involves the transfer of risk between more heavily exposed parties. As such higher levels of leverage will generally correspond with lower levels of risk.
A typical leverage ratio, or FLR, is the excess of current assets to current liabilities. This ratio takes current debt and current assets into account to calculate the maximum amount of credit that can be borrowed at any one point in time. Because current and future debt and assets will both increase over time, this number is a measure of potential equity. Ideally, a firm would have a positive FLR but would fail to make repayments on its existing debt and assets because of its poor borrowing ability.
Credit leverage is when a firm has access to more assets than its total current debt and liabilities. Usually, it is only when the amount of assets that can be leveraged goes above ten percent that problems arise. Credit leverage occurs most often in mergers and acquisitions where the acquisition company has access to more finance than the original holder of the debt. For instance, when a business is purchased by a firm that owns a large amount of real estate, the acquired company may be able to leverage its real estate investment. Consolidation loans are another example of leveraged debt because they give business owners the ability to increase their available borrowing capacity.
Other measures of financial leverage ratios use information on both debt and assets as the denominator. An example of this would be calculating current market value of an enterprise. This would not allow for the consideration of intangibles such as knowledge, technology, goodwill, or the intangible property of an enterprise. Therefore, there are different methods that an owner or manager may use to arrive at the ratios of capital to working capital. One method is to apply the gap between current assets and current liabilities as the numerator of the calculation. Another method would be to calculate the difference between net worth or market value of the business and current net worth or value of the business.
Another commonly used ratio is the ratio of current to long-term assets or current to short-term assets. These ratios take into account current and long-term tangible assets such as equipment, land, plant, and inventory. They also take into account current and long-term financial liabilities such as accounts payable, accrued expenses, and other liabilities. The calculation of leverage ratios is not entirely straightforward because some firms that own substantial amounts of non-equitable sources of debt may appear to have high ratios of assets to liabilities. It is also difficult to determine whether the size of the firm’s assets or liabilities affects its ability to service its financial obligations with respect to those assets and liabilities.
One of the most widely used ratios of capital to equity is the ratio of total debt to total equity. This figure, which is also called the EBIT or Employer Investment quotient, indicates the profit that a firm makes compared to the cost of borrowing money to finance assets. The higher the EBIT, the better the quality of the underlying financial transactions. A low EBIT would indicate that the firm is using funds in order to finance higher interest rate debt and buyout of fixed assets rather than making purchases of productive assets.
A third popularly used ratio of finance to determine the health of the finance industry in any country is the Debt to Growth Ratio or DGR. This measure compares the current market value of assets to the expected return on equity over the period of loan repayment. The higher the DGR, the greater the risk to lenders in providing credit facilities to a company. A high DGR indicates that the company is making an effort to repay its debt while at the same time increasing its ability to finance its operations.
Other measures of risk include credit quality, the credit risk premium, the premium companies pay for credit-worthiness and the coupon spread premium paid by the investment-grade debt security. An investment bank that offers its client’s debt capital markets should be able to provide them with a full spectrum of available products from both the conventional and investment-grade debt markets. A key indicator of a sound institution in the world of finance is how it deals with its clients when it comes to providing financing.