[ Music ] >> 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. 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. Right? In the balance sheet. It's not just debt. Right? So one way to think about is that total assets if you look at the left-hand side and the right-hand side of the balance sheet, total assets are going to be equal to debt plus other liabilities, plus equity. 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. 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. Okay? Right, so right? Look at this, you know, for all years that we have here, Cablevision ends up having more liabilities than assets. 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? Right, can a company have negative equity? [ Silence ] Okay? And the answer is no, okay. A company that has negative equity, a company that has more liabilities than assets is effectively bankrupt. That means you do not have sufficient assets to pay for your liabilities. 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. 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. 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. 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. 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. 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 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. 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. [ Silence ]
