Leverage: Debt to asset, capital and equity ratio formula
For those who are learning how and where to invest money in Singapore as a beginner, it is important to know how much leverage a company has. As seen from our earlier post about how leverage can destroy a company, it is also important to understand how companies can use leverage for greater growth and profitability.
Before we go further into the discussion on leverage, it is important to briefly discuss the various formulas for leverage. Leverage can be calculated via various ways depending on the investor’s own perspective.
Debt to Asset: Total Debt Outstanding/ Total Asset
The most common leverage ratio you will find is the Debt to Asset. This helps to measure how much of the total assets is being financed with debt. If the debt to asset ratio is 40%, it will imply that the rest of the assets are being financed by equity.
Debt to Capital: Total Debt Outstanding/ (Total Equity+ Total Debt)
The least common form of leverage ratio you might find will be the debt to capital ratio, where capital is defined as the total sum of equity and debt employed.
Sidenote:
- It is worth pointing out that the definition of asset here is strictly in the accounting sense of the word and not in terms of how investors like Robert Kiyosaki defines it in Rich Dad and Poor Dad
As we dive deeper into the subject of leverage, some of you may start to wonder why there is a need for so many ratios when they are all essentially one and the same. i.e. If we have the Debt/Asset number we can derive the Debt to Equity number. The reason for having somewhat similar ratios is that it allows us to interpret the absolute level of debt somewhat differently based on the different denominator used.
Debt as an attractive proposition
As mentioned in our post on Distribution and Value Accretion, debt is often used when the managers of the REIT attempt to increase the distributable income to unitholders. In short, as long as the REIT manager is able to pay less interest for the additional debt than the net property income form the newly acquired property, it would technically have created a DPU accretive situation for the unitholders. However, the value of a good leverage strategy goes beyond the realm of REIT investing. When a company replaces equity with debt, the very act of doing so increase the return of equity for the shareholders. Further, it also reduces the cost of capital as debt is typically less expensive than the cost of equity which takes into consideration both the risk free rate, the market beta as well as the equity premium.
We hope you have enjoyed this post as much as we have enjoyed writing it.
