3 min
10 September 2024
Financial leverage ratio definition
The financial leverage ratio is a critical measure that assesses the degree to which a company uses borrowed funds to finance its operations. It is an indicator of the proportion of debt used relative to the company's equity and capital structure. Companies often rely on this ratio to understand their financial health and risk exposure, as a high financial leverage ratio signifies that a company is more dependent on debt financing. The ratio plays a significant role in evaluating a company’s ability to meet its long-term obligations.A company with a high leverage ratio might face difficulties during economic downturns, as their debt obligations might become unmanageable. Conversely, a lower leverage ratio indicates that a company is using less debt and more equity to finance its operations, which generally implies lower risk. Analysing the financial leverage ratio through a company’s cash flow statement can provide insights into how effectively the company is managing its capital structure.
Why is it important for small businesses?
- Risk management: Small businesses with a balanced financial leverage ratio can better manage risks associated with debt and equity financing, ensuring their long-term viability. A high ratio might expose the business to increased financial stress during downturns, potentially leading to insolvency.
- Access to credit: Maintaining an optimal financial leverage ratio can enhance a small business's ability to secure loans, as lenders assess this ratio to determine the company's risk level when approving credit or business loans.
- Asset utilisation: Proper leverage allows small businesses to use their assets more effectively, maximising returns without overburdening themselves with debt. An unbalanced ratio could result in inefficient asset utilisation.
- Equity and liability management: For small businesses, maintaining the right balance between equity and liability is essential for sustaining growth. An optimal financial leverage ratio ensures that the business can attract investment and grow without excessive financial strain.
What is the financial leverage ratio formula?
- Basic formula: The financial leverage ratio is typically calculated by dividing the total debt by the total equity. The formula is expressed as:Financial Leverage Ratio = Total Debt / Total Equity
- Extended formula: In some cases, the ratio can also be calculated by dividing total assets by total equity, which provides a broader perspective on how much of the company’s assets are financed through debt.
- Interpretation: A ratio above 1 indicates more debt than equity, suggesting higher risk, while a ratio below 1 indicates more equity than debt, implying a more conservative financial structure.
4 types of financial leverage ratios
Financial leverage ratios help businesses assess their debt levels and financial health. Understanding these ratios enables companies to make informed decisions regarding debt management and capital allocation.1. Debt-to-Assets Ratio
The debt-to-assets ratio measures the percentage of a company’s assets that are financed through debt. It is calculated by dividing total debt by total assets. This ratio provides insight into how much of the company's assets are funded by borrowing, reflecting the overall financial risk. A higher ratio indicates higher leverage and, therefore, greater financial risk.
2. Debt-to-Equity Ratio
The debt-to-equity ratio is a comparison of a company's total debt to its shareholders' equity. This ratio reveals the proportion of company financing that comes from creditors versus shareholders. A higher debt-to-equity ratio means that more debt is being used to finance the business, which may increase risk during economic downturns.
3. Debt-to-Capital Ratio
The debt-to-capital ratio evaluates the proportion of debt in the company’s total capital structure. It is calculated by dividing total debt by the sum of debt and equity. This ratio helps in understanding how a company’s operations are financed, and a higher ratio indicates a higher reliance on debt financing, which can lead to increased financial risk.
4. Debt-to-EBITDA Ratio
The debt-to-EBITDA ratio measures a company’s ability to pay off its incurred debt based on its earnings before interest, taxes, depreciation, and amortisation (EBITDA). It is calculated by dividing total debt by EBITDA. A lower ratio indicates a company’s stronger ability to repay its debt from operating earnings, while a higher ratio suggests greater financial risk.
How to calculate the financial leverage ratio?
To calculate the financial leverage ratio, follow these steps:- Determine total debt: Calculate the sum of all short-term and long-term debts that the company owes.
- Determine total equity: Calculate the total shareholders' equity, which can be found on the company’s balance sheet.
- Apply the formula: Use the formula Financial Leverage Ratio = Total Debt / Total Equity. This ratio will indicate the proportion of debt financing in the company’s capital structure.
- Analyse the result: Compare the calculated ratio with industry standards to assess whether the company has a healthy level of leverage. Regularly monitoring this ratio helps in managing the company’s financial risk.
What is a good financial leverage ratio?
A good financial leverage ratio varies depending on the industry and the company’s risk tolerance. Typically, a ratio between 1 and 2 is considered acceptable for most industries, as it suggests a balanced mix of debt and equity financing. A ratio below 1 indicates that the company is primarily financed by equity, which usually implies lower financial risk but may also suggest underutilisation of debt as a growth tool. Conversely, a ratio significantly above 2 may indicate that the company is over-leveraged, which could lead to financial instability, especially during economic downturns. However, some industries, such as utilities, may operate with higher leverage ratios due to the nature of their capital-intensive operations. Therefore, it is crucial to compare the company’s ratio with industry benchmarks to determine whether it is managing its leverage effectively.4 key strategies for managing and optimising financial leverage ratio
Managing and optimising the financial leverage ratio is crucial for maintaining financial health and ensuring long-term sustainability.1. Issue equity
Issuing equity is a key strategy to reduce reliance on debt financing. By issuing more shares, a company can raise capital without increasing its liabilities, which lowers the financial leverage ratio. This approach helps balance the company’s capital structure and reduces financial risk, making it more attractive to investors.
2. Enhance profitability
Enhancing profitability is vital to improving the financial leverage ratio. By increasing profits, a company can use its retained earnings to pay down debt, thereby reducing the debt component of the ratio. This strategy not only improves the financial leverage ratio but also strengthens the company’s financial position by decreasing reliance on external funding.
3. Purchase back stock
Repurchasing stock can also be an effective strategy for managing financial leverage. When a company buys back its shares, it reduces the equity portion of the ratio, which can help in maintaining a desired level of leverage. However, this strategy should be used cautiously, as it can increase the company’s debt-to-equity ratio if done excessively.
4. Use financial derivatives
Utilising financial derivatives, such as options and swaps, can help manage the financial leverage ratio by hedging against risks associated with debt. These instruments allow a company to stabilise its cash flows and manage interest rate exposure, which can positively impact the leverage ratio by reducing the volatility of earnings and protecting against potential losses.
