The leverage ratio is a measure of the proportion of a company’s debt to its enterprise value. It is the most viable parameter in ascertaining the debt sustainability of an organization and may range depending on the company’s operations. While high debts are unfavorable at face value, they may be most effective in other organizations where the leverage ratios are relatively high. Similarly, some industries prefer to maintain low leverage translating to lower debts in general (Wu & Zhao, 2016). In the figure, firms in the electric utilities, airlines and paper products industries as well as the real estate investment trusts have high leverage averages. In contrast, firms in the apparel and luxury goods, footwear, computer hardware and data processing industries have low leverage. It occurs, therefore, that each of these industries is uniquely favored by a particular debt leverage level.
It is no coincidence that firms in the real estate investment trusts, airlines and paper products industries have relatively high debt leverage. Rather, each of these industries prefers to have their leverage ratios in that level to suit their different operations. Organisations in these industries are well aware of the implication of having a positive leverage ratio by having a lot of debt relative to their assets. The nature of the operations of these industries requires little cash flow and the best way to maximize on these occurrences is to have a huge debt load. These industries can then bank on the accumulated debt to make capital investments for long term returns on these investments. Essentially, the organizations in these industries use the money to get more profits for the organization because they require minimal cash flow anyway.
Still, the organizations in the computer hardware, footwear, apparel and luxury goods as well as those in data processing prefer low leverage ratios. The benefit of having a low debt ratio for these industries is manifested in the fact that there are high amounts of cash flow available. Indeed, the nature of these organizations requires liquidity in their assets to guarantee more cash flow. By maintaining low debt ratios, these organizations can guarantee a large proportion of their cash flow to the company’s daily operations. In addition, the nature of the organization’s operations fits the low debt ratios because they deal with fast moving products (Wu & Zhao, 2016). As thus, they have steady cash flow at their disposal at almost all times and thus do not need to take high debt.
Wu, H. M., & Zhao, Y. (2016). Optimal Leverage Ratio and Capital Requirements with Limited Regulatory Power. Review of Finance, rfv068.
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