Financial leverage, or the use of debt, is like a double-edged sword.
On the one hand, with the help of debt, companies could grow much faster. On the other hand, highly-leveraged companies generally carry high financial risks.
How to know a company's debt level?
The answer lies in the balance sheet.
A balance sheet is one of the three major financial statements.It provides detailed information about a company's assets, liabilities, and shareholders' equity at the end of the reporting period.
Assets are things of value that a company owns.
This can include physical property, such as plants inventory, equipment and inventory. It also includes things of value that don't physically exist, such as patents and brands. Cash is also an asset.
Based on liquidity, assets can also be divided into current and non-current assets.
Current assets are things that can be converted into cash within a year. Non-current are things that would take a company more than a year to sell.
Now let's take a look at liabilities.
Liabilities are a sum of money that a company owes.
This can be money borrowed from a bank or owed to suppliers or employees. Based on due dates, liabilities can be divided into current and long-term. Current liabilities are obligations a company expects to pay off within a year. Long-term liabilities are obligations due beyond one year.
The final thing is shareholders' equity.
It’s the money left if a company sold all of its assets and paid off its debts. This leftover money belongs to the company's shareholders or the owners.
Look at the balance sheet.
You can see that assets always have the same value as liabilities plus shareholders' equity.
We call it the accounting equation, which is a company's assets equal to the sum of its liabilities and shareholders' equity. This formula is always balanced. That's because a company has to pay for everything it owns by either borrowing money or taking it from investors.
The balance sheet is essential for investors to understand the current financial health of a company.Many tools can help you analyze a balance sheet.
One example is the debt-to-asset ratio.
The debt-to-asset ratio, also known as the debt ratio, compares a company's total debt to its total assets. It measures a company's ability to pay long-term obligations.
Generally speaking, a ratio below 1 means the company has more assets than liabilities and can meet its obligations by selling its assets if needed. The company generally has low financial risks.
A ratio equal to 1 means that the company owns the same amount of liabilities as its assets. It indicates that the company is highly leveraged and has a high financial risk.
A ratio greater than 1 means the company has more liabilities than assets. It indicates that the company is extremely leveraged and has very high financial risk.
However, a company with a high debt ratio doesn't necessarily mean it is highly risky. Debt ratios vary widely by industry. It depends on a company's business model.
For example, the financial sector, like banks, tends to have a much higher debt ratio as they borrow money in order to lend to customers.
Other industries that commonly show a relatively high debt ratio are capital-intensive industries, such as utilities, transportation, and energy.
Therefore, when analyzing if a debt ratio is good or not, the company's industry should also be taken into consideration.
To sum up, a balance sheet is an important financial statement and shows a snapshot of a company's assets, liabilities, and shareholders' equity at a specific time.
The debt ratio can be used to measure a company's financial risk. A high debt ratio is a red flag as it means most part of a company's earnings will go toward repaying debt.
This marks the end of the video. See you next time.