What is the margin of safety measure?

What will be an ideal response?

The margin of safety is defined as the percentage by which operating income could decline and still be sufficient to allow the company to meet its fixed obligations. The degree of leverage and margin of safety varies dramatically among industries. It is especially important to know the margin of safety if the company is believe to be highly leveraged company relative to some standard like an industry norm. More details are given below.

In computing a margin of safety, recognition must be given to other factors to make sure the margin of safety is accurately calculated. For example, one must see if the company has operating leases. Such leases represent an alternative to financing assets with borrowed funds. The existence of material operating leases can therefore understate a company's leverage causing the margin of safety to be overestimated. Thus, operating leases should be capitalized to give a true measure of leverage.

Two other factors should be considered: the maturity structure of the debt and bank lines of credit. With respect to the first, the one would want to know the percentage of debt that is coming due within the next five years and how that debt will be refinanced. For the latter, a company's bank lines of credit often constitute a significant portion of its total debt.