CMA2 Leverage Ratios

Question 1

Define: Liquidity

Answer 1

the company’s ability to pay short term debts
- Short term

Question 2

Define: Solvency

Answer 2

the company’s ability to pay long term debts
Long term

Question 3

Define: Operating Leverage

Answer 3

the degree to which a company’s operating income (EBIT) responds to changes in sales
- Affected by a company’s cost structure (variable and fixed costs)

Question 4

Define: Financial Leverage

Answer 4

the degree to which the company’s net income responds to changes in operating income (EBIT)
- Affected by a company’s capital structure (debt and equity)

Question 5

Degree of Operating Leverage (DOL)

Answer 5

DOL = Contribution Margin (CM) / Operating Income (EBIT)
- Can be calculated as a single year or multiple years
○ Multi-year formula
○ DOL = % Change in Operating Income (EBIT) / % Change in Sales (or Revenues)
§ If you want the current year’s value you need a forecast for the next year
○ CM = Sales - Variable Costs
○ EBIT = CM - Fixed Costs

Question 6

Financial Leverage Ratio (FLR)

Answer 6

FLR = Total Assets / Equity
- Also known as the Equity Multiplier
- Measures how many time the assets are available to shareholders

Question 7

Debt to Equity Ratio (DER)

Answer 7

DER = Total Debt / Equity
- Measures the proportion of total debt to total equity

Question 8

Debt to Total Assets Ratio (DTAR)

Answer 8

DTAR = Total Debt / Total Assets
- Measures what portion of the total assets are financed by debt

Question 9

Fixed Charge Coverage Ratio (FCCR)

Answer 9

FCCR = Earnings Before Fixed Charges and Taxes (EBFT) / Fixed Charges
- Measures the number of times a company’s earnings before fixed charges and taxes can cover its fixed charges

Question 10

Interest Coverage Ratio (ICR)

Answer 10

ICR = Earnings Before Interest and Taxes (EBIT) / Interest Expense

Question 11

Cash Flow to Fixed Charges Ratio (CFFCR)

Answer 11

CFFCR = (Operating Cash Flow (OCF) + Fixed Charges + Tax Payments) / Fixed Charges
- Measures the number of times a company’s operating cash flow before fixed charges and tax payments can cover its fixed charges

Question 12

Degree of Financial Leverage (DFL)

Answer 12

DFL = Operating Income (EBIT) / Earnings Before Taxes (EBT)
- Can be calculated as a single year or multiple years
○ Multi-year formula
○ DFL = % Change in Net Income / % Change in Operating Income (EBIT)
§ If you want the current year’s value you need a forecast for the next year
- EBIT = CM - Fixed Costs
- EBT = Operating Income - Interest Expense