3. Analyzing the Capital Structure

3.2. Leverage ratios

The same considerations apply when computing leverage ratios. The most commonly used leverage ratio divides the firm's total liabilities by the book value of equity. This is the so-called debt-to-equity ratio:

 

Debt-to-equity ratio = \( \frac{\text{Total liabilities}}{\text{Total equity}} \).

 

If we filter out operating liabilities and focus instead of the actual contributions from the providers of capital, an alternative version of the debt-to-equity ratio is:

  

Debt-to-equity ratio (Capital) = \( \frac{\text{Financial liabilities}}{\text{Total equity}} \).

  

Finally, if we focus on market values rather than book values, the debt-to-equity ratio is:

 

Debt-to-equity ratio (Market) = \( \frac{\text{Financial liabilities}}{\text{Market equity}} \).

 

When we apply these ratios to Hershey in 2015, we find the following (see the previous section for all the raw data):

 
Debt-to-equity ratio = \( \frac{\text{Total liabilities}}{\text{Total equity}} = \frac{4'296.9}{1'047.5} \) = 4.1.

 

Debt-to-equity ratio (Capital) =\( \frac{\text{Financial liabilities}}{\text{Total equity}} = \frac{2'420.5}{1'047.5} \)= 2.3.

 

Debt-to-equity ratio (Market) = \( \frac{\text{Financial liabilities}}{\text{Market equity}} = \frac{2'420.5}{19'400} \) = 0.12.

 

In terms of book values, Hershey has 4.1 times as many liabilities as equity and 2.3 times as many financial liabilities as equity. When we look at market values instead, the debt outstanding corresponds to only 0.12 times the market value of equity. Therefore, it is again important to understand the exact definition in order to interpret the ratio.

 

Debt and leverage ratios

Sometimes, we face a situation where we have to translate a debt ratio into a leverage ratio or vice versa. The following equations prove helpful in such situations. In these equations, D denotes the value of debt (financial liabilities) and E denotes the value of equity (E). Using this notation, the debt ratio is:

 

Debt ratio = \( \frac{D}{D+E} \)

 

and the leverage ratio is:

 

Leverage ratio = \( \frac{D}{E} \)

 

To see how the two ratios are related, let's divide the first equation by E, the value of the firm's equity. We get:

 

 \( \frac{D}{D+E} = \frac{\frac{D}{E}}{\frac{D}{E}+\frac{E}{E}} \).

 

Put differently, the debt ratio equals:

 

Debt ratio = \( \frac{Leverage}{Leverage + 1} \)

 

In the Hershey's example above, we found a leverage ratio of 2.3. Using the above equation, this leverage ratio converts into a debt ratio of approximately 70%:

 

Debt ratio = \( \frac{Leverage}{Leverage + 1} = \frac{2.3}{2.3+1}\) = 69.8%

 

This is the same debt ratio (debt-to-capital) as we found on the previous page.