- Leverage is an important component
of increasing a company's return on equity.
More leverage means more assets,
more assets means more sales.
And more sales typically means more income
with that same initial owner investment.
So the benefit of leverage is that
we can increase the size of our business
and increase our profits by using somebody else's money.
That's the benefit of leverage.
But there are also risks associated with leverage.
Once you borrow money, you now have the relentless
fixed cost of that interest.
And whether things are going well or going poorly,
you still have to pay that interest.
So there are benefits to leverage,
there are risks to leverage.
Prudent leverage in a business can increase
the return on equity.
But leverage has to be used carefully,
it's a double-edged sword.
Let's go back to the Dupont framework
where we saw the benefits of business leverage.
In the Dupont framework, we're looking at
the three components of return on equity.
Profitability, efficiency, and leverage.
Let's take a look at leverage.
Investors put their investment in the company,
but what if that investment is not enough
to buy all of the assets
they need to fulfill their business objectives?
Well, they need to borrow money.
They need to leverage their investment.
That makes the business larger with the same
initial shareholder investment.
That's reflected in the asset-to-equity ratio,
a measure of leverage.
Now why does a business want more assets?
Because more assets generate more sales
and more sales typically means more net income.
With more leverage, a company's return on equity
can be higher.
Even with the same amount of shareholder investment.
So let's look at some specific measures of leverage.
Measures that are commonly used.
The debt ratio is a very simple measure.
Total liabilities divided by total assets.
We see that here for Nordstrom, the ratio is almost 90%.
For Dillard's, about 50%.
What does that 90% mean?
Well, of all the money that Nordstrom needed
to buy its assets, it borrowed about 90% of it.
Dillard's borrowed about 50%.
The rule of thumb is that for large companies,
a debt ratio is usually between 50 and 60%.
So when I see that 51% debt ratio for Dillard's,
I think; they're fine, they're normal.
They've leveraged, they've borrowed about the same amount
as most companies borrow.
When I see that debt ratio of Nordstrom
on the other hand of 90%, I would have some questions.
And they would all start with the word; why.
Anyway that's the debt ratio;
total liabilities divided total assets.
The fraction of financing that was
obtained through borrowing.
Now another measure of leverage is called
the debt-to-equity ratio.
This is computed as total liabilities
divided by total shareholder investment.
We see that number for Nordstrom is eight,
and for Dillard's it's about one.
And at this point we need to stop
because I'm sure you're wondering;
now wait a second, what is the measure of leverage?
Because we saw in the Dupont framework
assets-to-equity ratio.
Now we just saw the debt ratio
and now we're looking at the debt-to-equity ratio.
Which is the one?
How are they different?
Well it turns out they're all related
to the same underlying data.
It's just a question of what is being divided by what?
But each is getting at the underlying concept of leverage.
And why do we have three?
Well, it's just a matter of taste.
People use these different ratios
and they all reflect the same thing.
So, how do we know which one to use?
Well the way you know is to ask the person
on the other side of the table;
which leverage ratio are you using?
And that also means that when you're talking
with somebody and they say; the leverage ratio is 0.5,
you need to stop them right there and say;
wait, are you talking about the debt ratio,
debt-to-equity ratio, or asset-to-equity ratio?
You cannot interpret the number
until you know what ratio is being used.