0:14

>> So now we we'll talk

about solvency ratios, or leverage ratios.

Those two are synonyms.

You can use either term.

Okay? And the first thing we need to talk about is

that there are several debt ratios

and in particular there is one specific debt ratio

that is commonly used that I recommend that we do not use it,

but I so want to talk about it in this introduction.

Okay? So the three ratios we'll talk about our debt over assets.

That divided by debt plus equity and liabilities plus assets.

Every time we use the term "debt", you should think of that

as the sum of short-term and long-term debt.

So we are considering both short-term

and long-term liability.

0:54

Okay? To understand the difference

between these leverage ratios, the best way to do this is

to look at a simplified balance sheet.

Which is what you have here.

Okay? So you have debt, you know, and other liabilities

in the right hand side, that you have the assets

on the left-hand side.

In particular you have to--

we have to think about the liability side.

Okay? So notice that total liabilities

of a company are going to be the sum of the debt

which you can think of as a financial liability plus other

liabilities like pensions and accounts payable, okay?

Which we talked about when we discussed our liquidity ratios

for example.

So their other liabilities.

1:54

Okay? So the problem is that if you use ratio number one,

debt over assets-- okay, what the problem is

that dividing debt over assets is going

to ignore the other liabilities such as pensions, right?

Other liabilities are part of assets, right?

Assets equals debt plus other liabilities plus equity.

But you're not including it in the numerator.

Okay? So that over assets may underestimate leverage

for some companies if a company has a lot of accounts payable,

or if a company has many, you know, large value of pensions,

that the company owes to its employees,

then we might be underestimating leverage

and we might be overestimating solvency.

Okay? For that company.

So what I do is I usually prefer to look at two and three.

So you either divide debt by debt plus equity, okay,

so here what you're doing is essentially ignoring the other

liabilities, but both in the numerator

and in the denominator.

Right, so we're not including other liabilities

in the numerator; we're not including other liabilities

of the denominator.

Okay? Or, the other thing you could do is

to include everything.

Right? So that would be ratio number three

where we divide total liabilities by total assets.

3:21

Okay? So, my recommendation is that we look at ratios two

and three, but I wanted to discuss debt over assets

because that is a commonly used debt ratio

that you might encounter in--

if you are reading about the companies in another source

or in a textbook, so I thought it was important

that we discuss that.

So let's focus on two and three and as we did

for the first section, I want to talk about the calculation

of these leverage ratios using data for real-world companies.

So here we are going to focus on Cablevision as we did

when we discussed the liquidity ratios, okay?

And then think about how much leverage does Cablevision have?

Okay we-- so this is the data here on the left-hand side.

You have data on the current capitalization of Cablevision,

so you have data on the current stock price

and the current market capitalization,

so that is the market value of equity.

Okay? You also have data on total debt,

and other right-hand side,

what I did is I gave you a simplified version

of the balance sheet of the company okay?

So we have assets and liabilities.

The first thing to notice here if you look at this data

for a while, okay, is

that Cablevision has more liabilities than assets.

4:55

Right? So what's the, you know,

there is something strange here, right?

So Cablevision seems to have more debt than assets, okay?

And if you check later, the data for DirecTV, you're going

to see the same thing, okay?

So here's the question for you to think about:

can a company have negative assets?

Right, can we have liabilities greater than assets?

5:46

Right? So that is not a stable situation, right?

And it means that you know,

that this company should actually disappear,

it should be sold off.

Something should happen.

Okay? And if you look at the data, you will see

that Cablevision and DirecTV are actually not bankrupt.

Right? They have a positive market value.

They are trading, you know, these are operating companies,

so there's something wrong here.

6:12

Right? What's going on?

The problem as going to learn now, is book equity.

Okay? So, we can-- it turns out that it--

we cannot use the book equity to compute--

to calculate leverage ratios.

And the reason is because of something we actually discussed

in the previous module in Module 1, right, which is the idea

that the book value equity does not reflect the future.

Okay? Does not include future cash flows.

The book value of the equity depends on, you know,

what happened up to this point of time.

Okay? It only includes what happens

in the past it does not include the value of future cash flows.

6:52

And if you want to know whether a company's solvent or not,

you need to think about the entire value

of the company not just the book equity.

Okay? So to measure leverage, we need to do is we really need

to use the market value

of equity rather than the book value.

And when we think about market value of equity,

we're going to be thinking

about the stock price times shares outstanding,

which is one way that you can compute the market value

of equity for a company that is publicly traded.

Okay? So, this example shows the importance

of calculating leverage ratios based on market value.

All right you would-- your answer would not make any sense

if you were using book values.

7:34

So, these are the ratios that we are actually going

to think about.

Okay? So, instead of using book equity,

we're going to use the market value of equity, so it's going

to be debt divided by debt plus the market value of equity,

and then the second ratio is going

to be total liabilities divided

by the market value of assets, okay?

And so what's the definition of market value

of assets, that's very simple.

All you need to do is to add total liabilities

to the market value of equity and you would get that.

Okay? So let's look at an example.

8:10

Here is the data for DirecTV

that I mentioned a few minutes ago.

Okay? So again, here you have the market capitalization

for DirecTV.

That is the current market value of equity for the company, okay?

You also have the data on total debt

that we're going to need, okay?

And you have the data on total liabilities.

As we did for the liquidity ratios,

let's do these calculations using the most recent data.

8:37

Okay? Especially for leverage ratios, I really make sense

to use the most recent data because we are using data

on the market value of equity so we need current data.

We need data that reflects the value of the firm as of today.

Right? So here on the bottom you have the calculations for you.

The market value of equity which we are pulling out directly

from the data, and then the market value of assets right

which is just the sum of total liabilities which you have here

with the market value of equity.

Okay? So with those numbers, it should be very simple

9:14

to compute the leverage ratios, right, for both DirecTV

and Cablevision, okay?

So for example, the liabilities over assets

for DirecTV would be 0.38, right?

All you need to do is to divide the liabilities

from the balance sheet by the market value of assets

that we calculated in the previous slide.

Okay? So and you can do a similar calculation

for Cablevision.

Here in the bottom, I put the value of the market value

of assets of Cablevision for you for your reference, so again,

you to do is to divide the total liabilities by the market value

of assets or divide that plus--

divide debt by the sum of debt plus equity.

10:03

Okay? And you would get these ratios here.

Right? So what is a good leverage ratio?

As we just discussed, definitely below one.

Right? A leverage ratio higher than one means

that a company is effectively bankrupt.

Right? So a company cannot have leverage ratio greater than one.

You know, it might actually disappear.

Okay. The average leverage ratio in U.S. companies is

between 25 to 30 percent.

So how much leverage should a specific company have?

That is a very important corporate finance topic

that we are not going to talk that much about in this course,

it's a topic that goes beyond what we can cover

in this course, so let's just keep these two numbers in mind

when we think about leverage ratios.

The average leverage ratio in U.S. companies is thought

of [phonetic] 30 percent, and you know,

you definitely cannot have leverage higher than one

or getting very close to one.

Okay? So, how does leverage get high?

As we discussed with the quiddity, it's important

to understand what the decisions would make a leverage get high.

Right? So every time a company issues debt to do something,

you're running the risk that your leverage may increase.

Right? So if you issue debt to repurchase equity,

that is a decision that would definitely increase your

leverage ratio.

Okay? If you issue debt to invest

in projects then it may be-- right?

Remember we are using the market value of equity

to computer leverage ratios.

You invest in a new project, you know, the market value

of equity may increase.

That's something we're going to talk about in Module 3.

So, your leverage ratio may go up or down,

but if the market value of assets doesn't increase

that much, then you are--

your leverage ratio may end up higher.

Okay? And finally,

poor performance is always a reason why a leverage

may increase.

Right? So if the company does poorly, equity value goes down,

right, and the leverage ratio is going to increase mechanically.

So poor performance, again,

is a reason why your leverage might get too high.