What is Leverage Ratio?
A leverage ratio is a financial ratio that helps to measure a company’s debt levels. It is a measurement that determines a company’s sustainability towards its borrowing practices. As a backstop measure, the leverage ratio is the proportion of equity to assets. Simply put, it captures all debts/liabilities regardless of their listing.
Businesses need financing in the form of debt and equity. Not only do they need finance to expand their operations, but to purchase assets, to act as sufficient working capital, and for debt restructuring. The money comes from investors and financial institutions.
To generate earnings, businesses need to control their debts. If the return on investment earned on capital is higher than the interest paid on loans and liabilities, the shareholders’ wealth increases.
Financial Leverage Ratio Formula
There are several types of ratios categorized as leverage ratios. They include:
Debt to Capital – this ratio compares the capital of a company to its debt. Used to analyze the financial structure of a business, the Debt to Capital ratio also measures how a business is being financed. The formula is: Debt to Capital = (Total Debt / (Total Debt + Total Equity)).
Debt to EBITDA – this ratio measures the capacity or ability of a company to pay off its debts. Typically used by financial institutions and credit rating agencies, the Debt to EBITDA ratio helps to determine how efficient the company can clear its debts. The formula is Debt to EBITDA = (Total Debt/EBITDA (Earnings Before Interest Taxes, Depreciation, and Amortization)).
Debt to Total Asset – this ratio measures the relation of a company’s assets to its total debt. Simply put, the ratio helps to measure how much debt the company used in purchasing assets. The formula is Debt to Asset = (Total Asset/Total Assets).
Debt to equity – this ratio measures the proportion of a company’s equity and debt. Commonly used by the banking industry as part of its credit appraisal exercises, the ratio compares the bank’s investment in the business to the investment made by the owners. The formula is Debt to Equity = (Total Debt/Total Equity).
What Does the Leverage Ratio Mean?
Investors and financial institutions need to use leverage ratios to analyze businesses in need of loans. The leverage ratios inform the investors, financial institutions, and even credit rating agencies about the operational efficiency of a company.
These ratios also offer an insight into the company’s financial health and its ability to meet debt repayment with efficiency. Investors and financial institutions use them to understand a company’s capital structure.
If the company’s debt to equity ratio is high, investors and financial institutions may decide against extending any credit to the company. But, if its debt to equity ratio is 2 or below, and the company’s performance is promising, investors and financial institutions will be willing to loan funds to the business.
Leverage Ratio Example
The most commonly used leverage ratio is the debt to equity ratio expressed as follows:
Debt to Equity Ratio = Total Liabilities/Total Shareholders Equity
Let’s assume Company A has $5 billion in equity and $10 billion as debt as of the financial year 2018. To know what the Debt to Equity ratio for Company A is, follow the process below.
Debt to Equity Ratio = Total Liabilities/Total Shareholders Equity = $10 billion/$2 billion = 5
The Debt to Equity Ratio for Company A is 5. What this informs financial experts is that the company has acquired more debt to finance its expansion. With the company’s liabilities at 500% of the shareholders’ equity, it can result in inconsistent earnings.
This is brought about by the interest expense as a result of the debt. What you need to know is that a Debt to Equity ratio of 2 and over indicates a risky business to an investor. While this may vary between industries that require more loans for asset purchase and growth, its essential for companies to borrow what they can meet with efficiency.
Final Thoughts
Leverage ratios help in measuring the company’s financial health, its capital structure, its solvency, and its ability to settle debts with efficiency.
Used by investors, financial institutions, and management, leverages ratios measure the efficiency at which the company is using the financial obligation to run the business. Credit rating agencies also rely on leverage ratios to extend credit to companies.
If a company’s debt ratio is high, it means a significant amount of its cash flow is for settling debts.
As such, if the interest rates were to increase, the company could default on its debts. But, if the debt ratio is low, a large portion of the company’s cash flow is not used in settling debts. From an investor’s point of view, such a company has the opportunity to grow responsibly.