0:14

>> So now we we'll talk

Â about solvency ratios, or leverage ratios.

Â Those two are synonyms.

Â You can use either term.

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

Â that there are several debt ratios

Â and in particular there is one specific debt ratio

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

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

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

Â That divided by debt plus equity and liabilities plus assets.

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

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

Â So we are considering both short-term

Â and long-term liability.

Â 0:54

Okay? To understand the difference

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

Â to look at a simplified balance sheet.

Â Which is what you have here.

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

Â in the right hand side, that you have the assets

Â on the left-hand side.

Â In particular you have to--

Â we have to think about the liability side.

Â Okay? So notice that total liabilities

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

Â which you can think of as a financial liability plus other

Â liabilities like pensions and accounts payable, okay?

Â Which we talked about when we discussed our liquidity ratios

Â for example.

Â So their other liabilities.

Â 1:54

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

Â debt over assets-- okay, what the problem is

Â that dividing debt over assets is going

Â to ignore the other liabilities such as pensions, right?

Â Other liabilities are part of assets, right?

Â Assets equals debt plus other liabilities plus equity.

Â But you're not including it in the numerator.

Â Okay? So that over assets may underestimate leverage

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

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

Â that the company owes to its employees,

Â then we might be underestimating leverage

Â and we might be overestimating solvency.

Â Okay? For that company.

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

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

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

Â liabilities, but both in the numerator

Â and in the denominator.

Â Right, so we're not including other liabilities

Â in the numerator; we're not including other liabilities

Â of the denominator.

Â Okay? Or, the other thing you could do is

Â to include everything.

Â Right? So that would be ratio number three

Â where we divide total liabilities by total assets.

Â 3:21

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

Â and three, but I wanted to discuss debt over assets

Â because that is a commonly used debt ratio

Â that you might encounter in--

Â if you are reading about the companies in another source

Â or in a textbook, so I thought it was important

Â that we discuss that.

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

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

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

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

Â when we discussed the liquidity ratios, okay?

Â And then think about how much leverage does Cablevision have?

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

Â You have data on the current capitalization of Cablevision,

Â so you have data on the current stock price

Â and the current market capitalization,

Â so that is the market value of equity.

Â Okay? You also have data on total debt,

Â and other right-hand side,

Â what I did is I gave you a simplified version

Â of the balance sheet of the company okay?

Â So we have assets and liabilities.

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

Â for a while, okay, is

Â that Cablevision has more liabilities than assets.

Â 4:55

Right? So what's the, you know,

Â there is something strange here, right?

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

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

Â to see the same thing, okay?

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

Â can a company have negative assets?

Â Right, can we have liabilities greater than assets?

Â 5:46

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

Â And it means that you know,

Â that this company should actually disappear,

Â it should be sold off.

Â Something should happen.

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

Â that Cablevision and DirecTV are actually not bankrupt.

Â Right? They have a positive market value.

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

Â so there's something wrong here.

Â 6:12

Right? What's going on?

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

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

Â we cannot use the book equity to compute--

Â to calculate leverage ratios.

Â And the reason is because of something we actually discussed

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

Â that the book value equity does not reflect the future.

Â Okay? Does not include future cash flows.

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

Â what happened up to this point of time.

Â Okay? It only includes what happens

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

Â 6:52

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

Â you need to think about the entire value

Â of the company not just the book equity.

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

Â to use the market value

Â of equity rather than the book value.

Â And when we think about market value of equity,

Â we're going to be thinking

Â about the stock price times shares outstanding,

Â which is one way that you can compute the market value

Â of equity for a company that is publicly traded.

Â Okay? So, this example shows the importance

Â of calculating leverage ratios based on market value.

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

Â if you were using book values.

Â 7:34

So, these are the ratios that we are actually going

Â to think about.

Â Okay? So, instead of using book equity,

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

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

Â and then the second ratio is going

Â to be total liabilities divided

Â by the market value of assets, okay?

Â And so what's the definition of market value

Â of assets, that's very simple.

Â All you need to do is to add total liabilities

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

Â Okay? So let's look at an example.

Â 8:10

Here is the data for DirecTV

Â that I mentioned a few minutes ago.

Â Okay? So again, here you have the market capitalization

Â for DirecTV.

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

Â You also have the data on total debt

Â that we're going to need, okay?

Â And you have the data on total liabilities.

Â As we did for the liquidity ratios,

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

Â 8:37

Okay? Especially for leverage ratios, I really make sense

Â to use the most recent data because we are using data

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

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

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

Â The market value of equity which we are pulling out directly

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

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

Â with the market value of equity.

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

Â 9:14

to compute the leverage ratios, right, for both DirecTV

Â and Cablevision, okay?

Â So for example, the liabilities over assets

Â for DirecTV would be 0.38, right?

Â All you need to do is to divide the liabilities

Â from the balance sheet by the market value of assets

Â that we calculated in the previous slide.

Â Okay? So and you can do a similar calculation

Â for Cablevision.

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

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

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

Â of assets or divide that plus--

Â divide debt by the sum of debt plus equity.

Â 10:03

Okay? And you would get these ratios here.

Â Right? So what is a good leverage ratio?

Â As we just discussed, definitely below one.

Â Right? A leverage ratio higher than one means

Â that a company is effectively bankrupt.

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

Â You know, it might actually disappear.

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

Â between 25 to 30 percent.

Â So how much leverage should a specific company have?

Â That is a very important corporate finance topic

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

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

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

Â when we think about leverage ratios.

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

Â of [phonetic] 30 percent, and you know,

Â you definitely cannot have leverage higher than one

Â or getting very close to one.

Â Okay? So, how does leverage get high?

Â As we discussed with the quiddity, it's important

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

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

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

Â Right? So if you issue debt to repurchase equity,

Â that is a decision that would definitely increase your

Â leverage ratio.

Â Okay? If you issue debt to invest

Â in projects then it may be-- right?

Â Remember we are using the market value of equity

Â to computer leverage ratios.

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

Â of equity may increase.

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

Â So, your leverage ratio may go up or down,

Â but if the market value of assets doesn't increase

Â that much, then you are--

Â your leverage ratio may end up higher.

Â Okay? And finally,

Â poor performance is always a reason why a leverage

Â may increase.

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

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

Â So poor performance, again,

Â is a reason why your leverage might get too high.

Â