The leverage ratio

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Suppose you are an analyst in pharmaceutical industry for Bank of America. You collect the following data to estimate the expected growth rate of dividends and use it as an input for valuing an oil company’s common stock.
Return on Assets 10%
Profit Margin 8%
Debt/Equity 4.5
Payout Ratio 40%

a. The leverage ratio of this company is (sample answer: 3.50)
b. The company’s expected growth rate is (sample answer: 25.60%)

Sample Solution

The leverage ratio of the company can be calculated by dividing total debt by total equity. The formula for this is: Leverage Ratio = Total Debt / Total Equity. In this case, we have a Debt/Equity ratio of 4.5 so we can calculate the leverage ratio as follows: Leverage Ratio = 4.5 / 1 = 4.5

Alternatively, we could also use the Return on Assets (ROA) and Profit Margin to derive an estimate of the leverage ratio using DuPont Analysis which states that ROA is equal to net profit margin multiplied by asset turnover multiplied by financial leverage: ROA = Net Profit Margin × Asset Turnover × Financial Leverage.

We know that Return on Assets in this case is 10%, while Profit Margin is 8% so plugging these values into equation gives us Financial Leverage as follows:

Financial Leverage= 10/(8*1)= 3 50.

Therefore, the leverage ratio of this company is 3 50.

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