So whereas analysts start off their analysis with profitability ratios, they're also keenly aware of the fact that the operations of the corporation are not just funded by equity, but also by liabilities, by debt. And that debt has got certain consequences in terms of how these profitability ratios should be assessed and that is what this video is going to be all about. How do we account for leverage? Leverage catches what the firm tries to achieve by borrowing money rather than selling more equity. So whereas the profitability measures focus on the return to investors, the owners, shareholders, many firms have got significant liabilities on their balance sheet, debt. The owners of the debt, banks, bond investors, do not participate in profit sharing like the owners would. But they do expect that the loans, the bonds, get repaid. So, unlike equity, debt needs to be repaid with interest regardless of the financial circumstances of the corporation. Debt might have important consequences for the profitability of the firm. So whereas debt financing provides a significant tax advantage, interest expense after all is tax deductible, it also exposes the owners to significant financial distress risk. Financial distress would occur when the firm's operating cash flow happens to be insufficient to meet the current obligations on liabilities, the current liabilities that is. So more debt implies higher distress risk and may cause a conflict of interest between the firm's investors. The investors being the shareholders and the investors being the lenders to the firm. So whereas equity investors want the corporation to take risk, related to the facts that shareholders in corporations have got limited liability so they can capture the benefits of risk taking, whereas they are somewhat protected against the downside of excessive risk taking. At the same time, the debt investors will want the firm to avoid risky projects. Risky projects would potentially lead to insufficient cash flows for the corporation to repay debt. They do not get the benefits of the upside of taking risk, but would be significantly exposed to the downside of that risk. So accounting for the level of leverage is important to get a good understanding of how the performance of the firm gets attributed to the liabilities and the shareholders. First method that we will use to capture the indebtedness of the firm, the level of debt relative to equity is given here as the debt-equity ratio, the proportional use of debt financing relative to equity financing in the firms operations. It can be computed fairly straightforwardly using the book values that you find on the balance sheet. Alternatively, we can also use market values. And I will say a little bit more about it in a moment. So here, for the debt-equity ratio for Kellogg's in 2014, according to book value, we computed as $12.3 billion divided by $2.8 billion. Debt is significantly larger than book value of equity. That gives us a debt to equity ratio of 4.31. That would look remarkably high when we compare that across industries for the share market. But that might have something to do with the fact that what you find on the balance sheet is measured as a book value. So now let's compute the same ratio, the same debt to equity ratio, on the basis of market value, or at least the market value of equity. We still take the book value of debt in the numerator. So the same $12.3 billion of book value of debt divided by a market value of $23.5 billion of equity, significantly larger market value of equity than the book value of equity. And that delivers a more common debt to equity ratio across industries of 0.52, about 50% debt to equity ratio. So what does that difference tell you? Well it tells you that it clearly matters whether you take market values or book values. The significant difference between the debt to equity ratio of 4.3 versus 0.5. Which is correct? Well, that's a much more difficult question to answer. What we should technically have done in the debt to equity ratio at the bottom here, the $12.3 billion book value of debt is replace debt by market value of debt as well. But that metric is actually different, difficult, different and difficult to measure in practice. So for the sake of illustration, I've just indicated to you here the massive impact that taking market value of equity would have on a metric like debt to equity. Alternative to just considering debt over equity, we could also compute a a ratio known as the debt ratio, where we divide the same total debt as you will find it as total liabilities on the balance sheet divided by total assets, which would, of course, be liabilities plus equity in the denominator. So if we do this for Kellogg's for 2013, we find that the debt ratio was 0.77. If we do the same computation for 2014 for Kellogg's we see that the debt ratio has increased to 0.81. Again, both of these measures are used on the basis of the balance sheet information, the book values of equity. Market valuation would have had a significantly different outcome. But the relative comparison over time, of course, is valid, so we see that the debt ratio from Kellogg’s has gone from 0.77 and marginally increased to 0.81. So over this time period, 2013 to 2014, Kellogg's became more indebted. But that is just giving us an indication of the possible size of the problem, the problem being the risk of ultimately ending up in a situation where there is financial distress. So a much better measure to capture that immediate likelihood of financial distress is the next ratio we look at, Interest Coverage Ratio, where we take one of these income metrics that you've seen when we discussed the profit and loss statement, EBIT, Earnings Before Interest and Taxes and divide that through by the interest expense, what we need to repay to the liability holders. That captures the ability of the firm to generate sufficient income to actually meet its interest expense obligations. So if we compute this metric for Kellogg's, we find that Kellogg's was making $1 billion in 2014 of net income of earnings before interest and taxes, I should say and divide that through by the interest expense of 209 million for the financial year 2014. And that gives us a healthy interest coverage ratio of 4.95. So clearly, Kellogg's is not in immediate financial distress. So summing up, these metrics which capture leverage, which capture the risk of the firm entering financial distress, is given here with the debt to equity ratio, compared between Kellogg's and Kraft, the debt ratio, the debt to total assets for Kellogg's and Kraft, both for 2014 and 2013, and the interest coverage ratio. What you should noteice by now with these competitor’s comparisons is the close similarity between these two corporations, which is truly worth noting.
