Question

However, a highly leveraged company puts the cash flows into stress as the debt has to be serviced periodically (mostly monthly or quarterly) irrespective of business's cash flow generation. If the debt service coverage ratio is not within the reasonable limit, it signifies that the business ability to repay debts as per their repayment schedule is in doubt. This would restrict banks to further extend the credit to those companies. Also, the credit rating of the company would get affected if the leverage is high.

If the ratio of equity to Assets is low, then RoA (return on Assets) would be low compared to RoE (Return on Equity). This can be observed from the formula:

RoA = Return on Assets (RoA) * Total Assets / Total Equity

Question: Reading about the high leveraged company, I would like to know what debt should be, what could we say that the company has a high leverage?

Answer 1

High leveraged companies are the ones which rely mor eon debt than equity for its capital requirements.

The ideal debt to equity ratio should be lower than 0.4

Debt ratio = Total Liabilities / Total Assets. Companies having ratio above 0.6 are said to be high leveraged companies.

Another ratio used to calculate leverage can be the debt service coverage ratio. This ratio tells us the cash flow available to pay current debt obligations. It can be calculated as follows : Net operating income / Total debt service. Thus a debt service coverage ratio of more than 1 will mean that the company has e ough cash to pay off its debt obligations in that year and a ratio below 1 will mean negative. A company with lower debt service coverage i.e. near 1 can be said to be high leveraged