Positive leverage will normally cause the rate earned on stockholders’ equity to ex-
ceed the rate earned on total assets. This occurs when the rate earned on total assets is
positive. Negative leverage will normally cause the rate earned on stockholders’ eq-
uity to be less than the rate earned on total assets. This occurs when the rate earned
on total assets is negative. Firms that have significant debt and negative leverage are
candidates for bankruptcy. Highly leveraged commercial airlines, such as United
AirlinesandDelta Air Lines, faced this problem in the mid-2000s.
The rate earned on stockholders’ equity can be compared to the rate earned on to-
tal assets by using the leverage formula, shown previously, where leverage is mea-
sured as the average total assets divided by the average stockholders’ equity:Rate Earned on Stockholders’ Equity = Rate Earned on Total Assets LeverageBoth Pixar and DreamWorks have debt, but both have positive leverage. The im-
pact of leverage for these two companies is shown below. DreamWorks’ rate earned on
total assets was 23 percentage points (35.4 12.4) greater than Pixar’s, indicating sig-
nificantly stronger performance in asset efficiency (as discussed in the previous section).
DreamWorks’ rate earned on stockholders’ equity, which is the ultimate concern
of stockholders, is 68.7 percentage points (81.8 13.1) greater than Pixar’s. Thus,
DreamWorks supports more assets by each dollar of stockholders’ equity than does
Pixar (2.31 versus 1.05). That is, DreamWorks uses more leverage than does Pixar. As
such, DreamWorks is able to turn its strong rate of return on asset performance into an
even stronger rate of return on stockholders’ equity performance as compared to Pixar.Rate Earned on Rate Earned Leverage (Average
Stockholders’ on Total Total Assets/Average
Equity Assets Stockholders’ Equity)
Pixar 13.1% 12.4% 1.054a
DreamWorks 81.8% 35.4% 2.310b
a$1,138.50 ÷ $1,080.30
b$940.70 ÷ $407.25While positive leverage can improve a firm’s financial performance for its stock-
holders, leverage also carries risk. A business that cannot pay its interest expense or debts
on a timely basis may experience difficulty in obtaining further credit, and, thus, may be
forced into liquidating assets, curtailing operations, or even filing for bankruptcy.
Leverage analysis focuses on the ability of a business to pay or otherwise satisfy
its current and noncurrent liabilities. Thus, we can use leverage analysis to assess
whether DreamWorks’ use of leverage is too aggressive relative to its financial condi-
tion. Leverage is normally assessed by examining current and long-term balance sheet
relationships, using the following major ratios:Current balance sheet relationships
Current ratio
Quick ratioLong-term balance sheet relationships
The ratio of fixed assets to long-term liabilities
The ratio of liabilities to stockholders’ equity
The number of times interest charges are earnedCurrent Ratio
To be useful in assessing solvency, a ratio or other financial measure must relate to a
business’s ability to pay or otherwise satisfy its liabilities. Using measures to assess a
business’s ability to pay its current liabilities is called current position analysis. Such
analysis is of special interest to short-term creditors.646 Chapter 14 Financial Statement Analysis