4.5. Leverage indicators
Average cost of debt
The average cost of (interest bearing) debt is relevant to understand the cost of financing by third parties. It is common to observe that firms hold different types of products of debt, which differ not only in interest rates, as time length wise, commissions and other fees.
It won’t make sense to determine that the cost of financing of the company is its long-term bank loans if the debt has mostly short-term loans and equivalents (although short-term financing can be renewed over the periods). To meet the average cost of debt, you should use the following:
- \(Average\ cost\ of\ debt=\frac{Interest\ costs}{Interest\ bearing\ debt}\)
Interest bearing debt includes bonds, bank loans and equity holders’ loans.
Example case: Dutch Fabric Innovations
Let’s take into consideration the following elements related with the activity of DFI:
| Values in EUR | 2020 | 2021 | 2022 | 2023 | 2024 |
| Interest costs | 4 000,00 | 9 900,00 | 16 510,00 | 10 150,00 | 7 390,00 |
| Interest bearing debt | 100 000,00 | 221 000,00 | 386 000,00 | 349 000,00 | 232 000,00 |
| Average cost of debt | 4,00% | 4,48% | 4,27% | 2,90% | 3,18% |
DFI’s interest bearing debt accounts for the bank loan and the shareholders’ loans. This debt is an average between a certain year and the previous one. In 2021, DFI has both bank and shareholders’ loans with a value of 342 000,00€. In 2020, the value of the referred loans is 100 000,00€, therefore, the interest-bearing debt of 2021 is an average of these two values: 221 000,00€.
Given this, the average cost of debt is:
- \(Average\ cost\ of\ debt=\frac{9\ 900,00}{221\ 000,00}=4,48\)%
Example case: Golden Days
Let’s take into consideration the following elements related with the average cost of debt of Golden Days:
| Values in USD | 2019 | 2020 | 2021 | 2022 | 2023 |
| Interest costs | 400,00 | 800,00 | 1600,00 | 1600,00 | 2400,00 |
| Interest bearing debt | 10 000,00 | 15 000,00 | 30 000,00 | 40 000,00 | 50 000,00 |
| Average cost of debt | 4,00% | 5,33% | 5,33% | 4,00% | 4,80% |
From the table, we can see that the average cost of debt reaches its highest value in 2020 and 2021 through the following calculation
- \(Average\ cost\ of\ debt=\frac{800,00}{15\ 000,00}=5,33\)%
Even so, the ratio, which indicates the cost of financing the company, is very randomly behaved.
It’s important to note that, in the first five years, the only debt registered by the company corresponds to the shareholders’ loans, and that, through the years, the interest-bearing debt has to be presented as an average between the final and the initial year. For example, in the case of 2020, the company has shareholders’ loans of 10 000,00$ in 2019 and 20 000,00$ in 2020, which leads to an interest-bearing debt of 15 000,00$ in 2020.
Equity-to-permanent financing ratio
This ratio provides a comparison between a company’s equity and its permanent capital (which includes equity, but also forms of long-term debt.
- \(Debt\ capacity=\frac{Equity}{Permanent\ capital}\)
Example case: Dutch Fabric Innovations
Take into consideration the following components of DFI’ balance sheet:
| Values in EUR | 2020 | 2021 | 2022 | 2023 | 2024 |
| Equity | 127 278,66 | 264 403,21 | 874 088,57 | 2 381 535,00 | 5 100 529,04 |
| Permanent Capital | 127 278,66 | 381 403,21 | 979 088,57 | 2 474 535,00 | 5 181 529,04 |
| Equity-to-permanent financing ratio | 100,00% | 69,32% | 89,27% | 96,24% | 98,43% |
In 2019, DFI does not hold any bank loan and hence the Equity-to-Permanent Financing Ratio is 100% because only there is only equity as permanent capital. In 2020, the company asks for a bank loan and, being the first year of this obligation, 2020 is the year that presents a smaller equity-to-permanent financing ratio because it is when the debt to the bank is larger.
- \(Equity-to-permanent\ financing\ ratio=\frac{264\ 403,21}{381\ 403,21}=69,32\)%
As the company pays back the loan, the ratio increases, meaning that equity will have a larger proportion than permanent capital.
Example case: Golden Days
Take into consideration the following components of Golden Days’ balance sheet:
| Values in USD | 2019 | 2020 | 2021 | 2022 | 2023 |
| Equity | 163 031,76 | 384 414,62 | 650 950,85 | 868 272,23 | 1 117 582,52 |
| Permanent Capital | 163 031,76 | 384 414,62 | 650 950,85 | 868 272,23 | 1 117 582,52 |
| Equity-to-permanent financing ratio | 100,00% | 100,00% | 100,00% | 100,00% | 100,00% |
Golden Days presents an Equity-to Permanent Financing Ratio of 100% for all the years of the project. This happens because permanent capital includes equity and long-term debt, but the company does not resort to long-term debt in any of the years. So permanent capital will be equal to equity and the ratio is constant and equal to 100%:
- \(Equity-to-permanent\ financing\ ratio=\frac{163\ 031,76}{163\ 031,76}=100,00\)%
Interest coverage ratio
The coverage of financial charges demonstrates the company’s ability to generate sufficient operational funds to pay interests costs. A simplified form assumes that the EBITDA corresponds roughly to the cash flows that the company generates.
- \(Interest\ coverage\ ratio=\frac{EBIT}{Interest\ costs}\)
If the ratio is higher than 1, the company is generating sufficient funds to pay the interest costs and if it is less the opposite. A ratio less than 1 does not mean that the company cannot pay its interest costs. By resorting to surplus cash or to a change in working capital investment, the company may be able to meet its obligations.
You should be aware that this ratio is often calculated with the EBITDA rather than the EBIT on the numerator.
Example case: Dutch Fabric Innovations
| Values in EUR | 2020 | 2021 | 2022 | 2023 | 2024 |
| EBIT | -68 721,34 | 126 066,07 | 762 757,15 | 2 020 078,57 | 3 899 382,05 |
| Interest Costs | 4 000,00 | 9 900,00 | 16 510,00 | 10 150,00 | 7 390,00 |
| Interest coverage ratio | 0,00% | 1 273,39% | 4 619,97% | 19 902,25% | 52 765,65% |
With an EBIT of 126 066,07€ and interest costs of 9 900,00€, in 2021 DFI has an Interest Coverage Ratio of
- \(Interest\ Coverage\ Ratio=\frac{126\ 066,07}{9\ 900,00}=1\ 273,39\)%
From 2021 to 2024, the company presents a growth of the ratio, proving that it has a growing and strong ability to cover its interest costs.
Only in 2020 does it not generate enough operational funds to pay interests. Mathematically, the ratio for 2020 should be negative due to the negative EBIT of the same year. However, intuitively, this ratio represents how much of the interest debt the company can cover. With negative results, the company is not able to cover any part of the debt with its operational funds and, therefore, the interest coverage is 0,00%.
Example case: Golden Days
| Values in USD | 2019 | 2020 | 2021 | 2022 | 2023 |
| EBIT | -36 568,23 | 31 346,94 | 239 508,90 | 312 059,11 | 358 557,55 |
| Interest Costs | 400,00 | 800,00 | 1 600,00 | 1 600,00 | 2 400,00 |
| Interest coverage ratio | 0,00% | 3 918,36% | 14 969,30% | 19 503,69% | 14 939,89% |
With an EBIT of 31 346,94$ and interest costs of 800$, Golden Days has an Interest Coverage Ratio of 3 918,36% in 2020:
- \(Interest\ coverage\ ratio=\frac{31\ 346,94}{800,00}=3\ 918,36\)%
Between this year and 2022, the company presents a big growth of the referred ratio proving that it has a growing and strong ability to generate funds to cover its interest costs.
In 2023, the ratio decreases due to the bigger growth of the interest costs in comparison with the growth in EBIT.
Only in 2019 does it not generate sufficient operational funds to pay interests with them and so it may resort to other means such as surplus cash. Mathematically, the ratio for 2019 should be negative due to the negative EBIT of the same year. However, intuitively, this ratio represents how much of the interest debt the company can cover. With negative results, the company is not able to cover any part of the debt with its operational funds and, therefore, the interest coverage is 0,00%.
Debt service coverage rate
It is not just interest costs that are relevant, but also of the principal payments of bank loans. Debt service includes costs and the balance of disbursements and repayments of bank loans. The financial debt structure is composed of short-term and long term, whose terms of payments are usually set under contract. The coverage of the debt payments reflects the company’s ability to generate funds to pay its debt service.
- \(Debt\ service\ coverage\ ratio=\frac{Operational\ cash\ flows}{Debt\ service}\)
Example case: Dutch Fabric Innovations
| Values in EUR |
2020 | 2021 | 2022 | 2023 | 2024 |
| Operational cash flows | -68 721,34 | 126 066,07 | 762 757,15 | 2 020 078,57 | 3 899 382,05 |
| Debt service | 4 000,00 | 12 900,00 | 28 510,00 | 22 150,00 | 19 390,00 |
| Debt service coverage ratio | 0,00% | 977,25% | 2 675,40% | 1 173,44% | 4 911,67% |
DFI built its Debt Service Coverage Ratio for 2021 by dividing its operational cash flows by the debt service, which includes the interest costs as well as the installments of the bank loan.
- \(Debt\ Service\ Coverage\ Ratio=\frac{126\ 066,07}{12\ 900,00}=977,25\)%
We can see that, from 2021 to 2024, the Debt Service Coverage Ratio increases, but is lower in 2023. Nevertheless, the ratio is always above 100%, meaning that the company is able to cover both short and long-term debt.
In 2020, just like the interest coverage ratio, the debt service coverage ratio is also 0,00% because, since the company presents negative results for the operational cash flows, it will not be able to cover any part of its debt.
Example case: Golden Days
| Values in USD | 2019 | 2020 | 2021 | 2022 | 2023 |
| Operational cash flows | -36 568,23 | 31 346,94 | 239 508,90 | 312 059,11 | 358 557,55 |
| Debt service | 400,00 | 800,00 | 1 600,00 | 1 600,00 | 2 400,00 |
| Debt service coverage ratio | 0,00% | 3 918,36% | 14 969,30% | 19 503,69% | 14 939,89% |
Golden Days obtained its Debt Service Coverage Ratio by dividing its operational cash flows (EBIT) by the debt service. For example, in 2020 we have:
- \(Debt\ service\ coverage\ ratio=\frac{31\ 346,94}{800,00}=3 918,36\)%
It is possible to see that this ratio presents exactly the same values as the interest coverage ratio. This happens because, since the company does not incur into any bank loan during the 5 years, the only debt that is recorded is the interest costs.
This way, from 2020 to 2022, the Debt Service Coverage Ratio increases and decreases in 2023, once again due to faster growth of the interest costs. Despite these variations, the ratio is always bigger than 100%, meaning that the company is able to cover both short and long-term debt with the EBIT generated.
In 2020, just like the interest coverage ratio, the debt service coverage ratio is also 0% because, since the company presents negative results for the operational cash flows, it will not be able to cover any part of its debt.
Next Section: 4.6. Liquidity ratios