Q: What is a good leverage ratio?
A: The leverage ratio differs for different types of businesses. A company with relative large amounts of fixed assets and corresponding long-term deb would generally exhibit a higher leverage ratio than a retail operation, such as a shoe store, with little fixed assets in the form of property, plant, and equipment and associated debt.
What is important to understand is that various statistical studies have determined that movement in the leverage ratio is the most effective indicator of shifts in risk. An increase in leverage indicates that the risk of repayment has increased, and a decrease in leverage indicates that the risk of repayment has decreased for the following reasons:
- Lower leverage generally translates to less debt service per dollar of sales and, therefore, to more cash flow available to service debt, which is the preferred repayment source.
- Lower leverage also implies more cash from the liquidated value of assets vis-à-vis outstanding obligations, and, therefore, more cash available to pay obligations in the event of liquidation.
In every instance, we should also identify the primary causes for an increase or decrease in leverage. which forces us to focus on movements in the Business Drivers – sales growth, the gross margin, SG&A%, accounts receivable days, inventory days, accounts payable days, fixed asset spending, and the owner payout rate.
The owner payout rate is frequently instrumental in explaining movements in the leverage ratio. Distributions, for example, have a direct impact on net worth and, therefore, a direct impact on the leverage ratio. In the case of Total Coverage, Inc., the increases in receivables and inventory contributed to the increase in leverage, but the primary contributor to the increase was the impact of excessive distributions, which exceeded reported net income by $73,267 in 2018, thereby reducing net worth by that amount, i.e., by $73,267.
Course overview: Financial Statement Review and Ratio Analysis