Basic Finance 2 - Leverage ratios

Calculating liquidity ratios

To continue the series about financial ratios, this is a post to show how to calculate the main leverage ratios (another very important group of financial ratios).

Again, I want to go straight to practice, without getting into much detail about financial ratios.

I am going to use data from Magazine Luiza. You can download the data from here. The source of this spreadsheet is the website I can’t be sure this site is always correct. But in all the times that I checked, I’ve never found an error.

These are the top five leverage ratios for this company in the last quarter (2nd quarter of 2020).

This is the Total debt ratio:

$$Total\ debt\ ratio = \frac{Total\ debt}{Total\ assets} = 0.64$$

This is the Net total debt ratio:

$$Net\ total\ debt\ ratio = \frac{Total\ debt - Cash}{Total\ assets} = 0.58$$

This is the Debt to equity ratio:

$$Debt\ to\ equity = \frac{Total\ debt}{Total\ equity}= 1.76$$

This is the Net debt to equity ratio:

$$Net\ debt\ to\ equity = \frac{Total\ debt - Cash}{Total\ equity}= 1.61$$

This is the Equity multiplier:

$$Equity\ multiplier = \frac{Total\ Assets}{Total\ equity} = 2.76$$

And below, you can see the evolution of these ratios. Notice that the X-axis is inverted, so we need to look the evolution from right to left (see the axis' legend).

All ratios decreased slightly around 2017. Before and after 2017, the five ratios seem stable. It is almost like we have to split the period in two to make inferences. The trend is also slightly negative after 2017, suggesting the company still wants to de-leverage more.

My take of these numbers is that, though decreasing, they are a little bit high yet. But we have to consider one important aspect: the company has a lot of money invested in inventories (around 21% of Total assets). Thus, if the company faces some debt-related problems, considering its business, it should not be too hard to sell some inventories to pay back some debt and decrease leverage.

This only shows that we never should use one type of ratio without a look at other aspects of the company!

I will continue this series of indicators. We still are going to see Profitability ratios, Working Capital ratios, Valuation ratios, Operating returns ratios, Interest Coverage ratios, and some others.

I hope you like this series. Thanks for passing by!

Henrique Castro Martins
Henrique Castro Martins
Assistant Professor of Finance