Lesson: Debt/Leverage Ratios

Instructor: Nick Palazzolo

This lesson covers various debt or leverage ratios, focusing on the total debt ratio, debt to equity ratio, and times interest earned ratio. The importance of times interest earned ratio, which indicates a company's ability to cover its interest expenses, is explained in detail. The lesson also explores the concept of a levered firm and how the value of a levered firm is determined. Real-life examples are provided to illustrate how to calculate the value of a levered firm, taking into account the present value of interest tax savings. The analysis offers insight into the difference in value between a levered and unlevered firm and how companies benefit from interest expenses being tax-deductible.

Updated: June 22, 2023 Create an account

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Transcript

Instructor: Nick Palazzolo

Nick Palazzolo is head instructor of ExamPrep.ai CPA Review. Nick's teaching style is engaging & upbeat, combining practical Big 4 tax & assurance expertise with years of 1-on-1 coaching. His lessons are concise and emphasize what you need to know to pass. Whether you're a recent grad or working full-time, we’re confident you can conquer your CPA exams with Nick’s review.

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We've got some debt or leverage ratios. Here we go. Make sure you know these as well. A couple that I want to bring your attention to and highlight specifically total debt ratio and the debt to equity ratio. The times interest earned ratio. So this is just these are solvency ratios. Can you pay your bills and then times interest earned earnings before interest expense and taxes divided by interest expense. So just let's think of this earnings, right? What are you bringing in divided by interest expense? You want this to be higher because think about it. Your earnings are good and interest expense is bad. You don't want to pay interest expense. And what this is telling you is how much money you're making based on how much interest you're paying. Let's say you're making a lot of money. You're not paying a lot of interest. That's great. Let's say you're making a lot of money, but also paying a lot of interest. Well, maybe it makes sense, right? And that would just mean you're more leveraged. You're more levered. You are using more leverage. You're taking out more debt paying more interest because of that and maybe that money is being well used to help finance your earnings. Obviously, you don't want higher interest expense. You want this number to be as high as possible. Let's dive into another example. The value of a levered firm. We saw that previously. Well, what is the value of a levered firm and what is a levered firm that is a company or an entity that has leverage? What is that value of the company? It is the value of an unlevered firm, meaning the value of a company that has no debt plus the present value of the

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