A leverage ratio is a financial metric used in finance, business, and economics to assess the level of debt in relation to another financial measure. It helps determine the proportion of capital derived from debt (such as loans) and evaluates a company's ability to meet its financial obligations.
Common leverage ratios include the debt-to-equity (D/E) ratio, equity multiplier, debt-to-capitalisation ratio, degree of financial leverage (DFL), consumer leverage ratio, debt-to-capital ratio, debt-to-EBITDA ratio, debt-to-EBITDAX ratio, interest coverage ratio, and fixed-charge coverage ratio.
Leverage ratios are crucial in business and finance, as they provide insights into a company's reliance on debt versus equity to fund operations, helping assess its capacity to repay debts as they become due.
In this article, we explore what leverage ratios are, look at some examples and check out the common ratios used to assess leverage.
What is Leverage Ratio?
Leverage ratios are financial metrics that assess a company's debt relative to other financial measures. These ratios provide insights into the proportion of debt financing and a company's ability to meet its financial obligations. Common leverage ratios include the debt-to-equity ratio, equity multiplier, debt-to-capitalization ratio, degree of financial leverage, consumer leverage ratio, debt-to-capital ratio, debt-to-EBITDA leverage ratio, debt-to-EBITDAX ratio, interest coverage ratio, and fixed-charge coverage ratio.
Leverage ratios are crucial in evaluating a company's financial health as businesses often utilize a combination of equity and debt to fund their operations. Understanding the level of debt held is essential in assessing the company's capacity to repay its obligations as they mature.
Leverage ratio formula
When someone mentions the ‘leverage ratio’ without additional context, it's generally safe to assume they are referring to the debt-to-EBITDA ratio. This ratio is calculated by dividing the total debt by EBITDA for the corresponding period:
Debt to EBITDA Ratio = Total Debt ÷ EBITDA
In this calculation, EBITDA serves as a proxy for operating cash flow, aiming to determine whether the company generates sufficient cash flow to meet its financial obligations. While EBITDA is widely used, it does have limitations, such as not fully accounting for the cash effects of capital expenditures (CapEx). For capital-intensive industries with significant fluctuations in EBITDA due to variable CapEx, using (EBITDA – CapEx) can be more appropriate.
Additionally, tracking the senior debt ratio is crucial since senior lenders often impose covenants, although these restrictions have relaxed over the past decade. Some consider the net debt ratio a better measure of financial risk because it factors in cash reserves, reducing lenders' risk. Acceptable ranges for these ratios vary based on industry standards and market conditions.
How to calculate leverage ratios?
The process for calculating leverage ratios depends on the type of ratio being used. Typically, the rule of thumb is to divide one metric by another to understand how the two compare with each other. To further understand how leverage ratio calculation works, you need to be clear about the typical capital structure in businesses today.
As a rule of thumb, the following three components generally make up a company’s capital.
1. Common shares
Common shares, also known as equity shares, represent units of ownership in a company. These shares do not offer any preferential benefits. However, they come with voting rights and may pay out dividends if the company decides to distribute its profits to its shareholders.
2. Preferred shares
These shares do not come with any voting rights. However, in the event of liquidation, preferred shareholders enjoy priority for capital repayment when compared with equity shareholders of the company.
3. Debt
The debt component of a company’s capital structure includes loans and other credit facilities used to fund its asset purchases and operations. Such loans are essentially considered as capital that has been borrowed from banks, lending institutions and other lenders.
Leverage ratio calculation example
There are different types of leverage ratios based on the metric that is compared with a company’s debt levels. While we will look into the various leverage ratio formulas later in this article, let us discuss a simple example of this indicator.
Suppose there’s a company with the following balance sheet data:
Total Assets = Rs. 70 crore
Total Debt = Rs. 30 crore
Total Equity = Rs. 40 crore
To calculate the balance sheet ratios, we’d use the following formulas:
Debt-to-Equity = Rs. 30 crore ÷ Rs. 40 crore = 0.75x
Debt-to-Assets = Rs. 30 crore ÷ Rs. 70 crore = 0.43x
Debt-to-Total Capitalisation = Rs. 30 crore ÷ (Rs. 30 crore + Rs. 40 crore) = 0.43x
What does a leverage ratio tell you?
Leverage ratios are essential financial metrics that evaluate an entity's capacity to fulfill its financial obligations. Excessive debt can pose significant risks to a company's financial stability and investor confidence. However, judiciously employed debt can catalyse growth if the company's operations generate a return on investment that exceeds the cost of borrowing. Uncontrolled debt levels can lead to creditworthiness challenges or more severe consequences. Conversely, an overly conservative approach to debt can raise concerns about the entity's financial health and operating margins.
Leverage ratios can also be used to assess a company's operating cost structure, providing insights into how changes in output will impact operating income. The mix of fixed and variable costs varies across industries and companies, affecting the sensitivity of operating income to changes in sales volume. Additionally, the consumer leverage ratio, which compares consumer debt to disposable income, is a valuable tool for economic analysis and policymaking.
What are balance sheet leverage ratios?
Balance Sheet Leverage Ratios are financial metrics used to evaluate a company's capital structure and its reliance on debt versus equity to finance its operations. These ratios are important indicators of financial risk, measuring how much of a company's assets are funded through borrowing. The higher the leverage, the more debt a company has, which can amplify both potential returns and risks.
Key types of balance sheet leverage ratios:
1. Debt-to-Equity Ratio: This ratio compares total debt to total equity, indicating the proportion of a company’s capital structure that is funded by debt relative to shareholders' equity. Formula:
Debt-to-Equity = Total Debt ÷ Total Equity
2. Debt-to-Assets Ratio: It shows the percentage of a company’s assets that are financed by debt. A high ratio suggests a company is heavily reliant on debt for its operations. Formula:
Debt-to-Assets = Total Debt ÷ Total Assets
3. Debt-to-Capitalisation Ratio: This ratio measures the proportion of a company's total capital (debt + equity) that comes from debt, offering insight into its overall leverage. Formula:
Debt-to-Capitalisation = Total Debt ÷ (Total Debt + Total Equity)
These ratios help stakeholders assess a company's financial health, risk tolerance, and its ability to manage debt, guiding decisions related to lending, investment, and growth. High leverage can drive growth, but it increases the risk of financial distress.
What are cash flow leverage ratios?
Cash Flow Leverage Ratios assess a company's ability to meet its debt obligations using the cash it generates from operations. These ratios focus on the relationship between a company's cash flow and its debt, providing insights into the company’s financial stability and its capacity to service debt without relying on external funding or asset liquidation.
Key types of cash flow leverage ratios:
1. Debt-to-Cash Flow Ratio: This ratio compares a company’s total debt to its cash flow from operations, reflecting how many years it would take to repay debt using current operational cash flow. A lower ratio indicates healthier financial conditions. Formula:
Debt-to-Cash Flow = Total Debt ÷ Cash Flow from Operations
2. Interest Coverage Ratio (Cash Basis): It measures how easily a company can pay interest on its outstanding debt using the cash generated from its core business operations. Formula:
Interest Coverage Ratio = Cash Flow from Operations ÷ Interest Expenses
3. Cash Flow to Debt Ratio: This ratio shows how much of the company’s debt can be covered by its cash flow, highlighting its ability to repay short-term and long-term debt. Formula:
Cash Flow to Debt Ratio = Cash Flow from Operations ÷ Total Debt
These ratios provide critical insights into the company’s liquidity, debt repayment capacity, and financial resilience, helping investors and creditors gauge risk. A strong cash flow leverage position reduces default risks and financial distress.
List of common leverage ratios
Now that you know what leverage ratios are and how they are to be interpreted, let us examine some common ratios in this category.
1. Debt-to-asset ratio
This ratio compares the total debt in a company with its total assets. For instance, if the debt-to-asset ratio is 0.7, it means the company uses debt to finance 70% of its asset purchases.
This leverage ratio’s formula is:
Debt-to-asset ratio = Total debt ÷ Total assets
2. Debt-to-equity ratio
This leverage ratio measures a company’s debt levels against its equity levels. The higher the number, the more it indicates that a company relies too much on debt instead of equity to finance its growth.
This leverage ratio’s formula is:
Debt-to-equity ratio = Total debt ÷ Total equity
3. Debt-to-capital ratio
A company’s capital includes both debt and equity components. This leverage ratio compares the debt component of a company’s capital structure with its total capital. The higher the number, the more leveraged a company is.
This leverage ratio’s formula is:
Debt-to-capital ratio = Total debt ÷ (Total debt + Total equity)
4. Debt-to-EBITDA ratio
In this leverage ratio, you compare a company’s total debt with its EBITDA (or Earnings Before Interest, Taxes, Depreciation and Amortisation). It tells you how much income a company has to repay its debt before accounting for interest, taxes, amortisation and depreciation.
This leverage ratio’s formula is:
Debt-to-EBITDA ratio = Total debt ÷ EBITDA
5. Asset-to-equity Ratio
This ratio tells you how much of a company’s assets have been funded by a company’s shareholders. A low asset-to-equity ratio means that the company relies heavily on equity to fund its assets. Conversely, the higher this number, the more leveraged a company may be.
This leverage ratio’s formula is:
Asset-to-equity ratio = Total assets ÷ Total equity
Interpreting leverage ratios
The exact interpretation of leverage ratios depends on the metrics used in the ratio. Ultimately, each leverage ratio helps you evaluate the level of debt in a company. This essentially means that a high leverage ratio is a sign that a company relies more on borrowed money than issued capital. This may be manageable when the business is good but may become risky in a bad economy.
Conversely, a low leverage ratio is a sign of low debt in the company. This may suggest that the company relies more on equity capital to finance its operations. Ultimately, leverage ratios are vital for investors and creditors who wish to gauge the financial health of a company. By analysing these ratios, you can make informed decisions about investing in a company over the long term.
What is a good leverage ratio?
The optimal level of leverage varies depending on the specific ratio employed and the nature of the company. Capital-intensive industries typically rely more heavily on debt financing than service-based firms, resulting in higher leverage. To assess industry-standard leverage ratios, benchmarking is crucial. It's important to note that a low debt-to-equity ratio does not necessarily indicate financial strength. Strategic use of debt can enhance shareholder returns.
What is a high leverage ratio?
A high leverage ratio can be a red flag because it means the company relies heavily on debt to finance its growth and fund its asset purchases. This means that a significant portion of its revenue may be redirected to repaying its liabilities instead of furthering its business. For investors, this is not a good sign as it could hinder long-term growth and result in lower returns than expected.
Advantages and disadvantages of financial leverage
Financial leverage is a powerful tool that can significantly impact investment outcomes. It essentially involves borrowing money to increase your investment capacity. By using borrowed funds, you can control a larger asset base than your initial capital would allow, potentially amplifying both profits and losses.
Advantages:
- Amplified Returns: This is the primary allure of leverage. When investments perform well, borrowed funds contribute to significantly higher returns. For example, if you borrow money to invest in stocks and the stock price doubles, your profit will be much greater than if you had invested only your own capital.
- Access to More Opportunities: Leverage can open doors to investment opportunities that might otherwise be out of reach. It allows you to invest in assets like real estate or venture capital, which typically require substantial upfront capital.
- Strategic Financing: For businesses, leverage can be a strategic tool for financing short-term needs like acquisitions or buyouts. By borrowing funds, companies can seize opportunities quickly and expand their operations without diluting ownership or relying entirely on equity financing.
Disadvantages:
- Amplified Losses: The flip side of amplified returns is amplified losses. If your investments perform poorly, leverage magnifies your losses. You could end up owing more than your initial investment, potentially leading to significant financial distress.
- Increased Costs: Leveraged trading often involves additional costs such as interest payments, margin fees, and contract premiums. These costs can erode profits and reduce overall returns.
- Complexity: Leveraged trading can be complex and requires careful management and monitoring. Investors need to understand the risks involved and actively manage their positions to minimize potential losses.
Here's a breakdown of the pros and cons:
Pros |
Cons |
Amplifies Returns: Potentially higher profits |
Amplifies Losses: Increased risk of significant losses |
Access to More Opportunities: Enables investing in more expensive assets |
Higher Costs: Fees, margin rates, and contract premiums |
Strategic Financing: Useful for short-term needs like acquisitions |
Complexity: Requires careful management and monitoring |
Leverage Ratio vs. Coverage Ratio: What is the difference?
Leverage ratios impose a limit on how much debt a company can take on, while coverage ratios establish a minimum threshold that the company’s cash flow must stay above.
Leverage Ratios and Coverage Ratios both assess a company’s financial health but focus on different aspects. Leverage ratios measure the extent of a company's debt relative to its equity or assets, providing insight into its reliance on debt for financing. Key leverage ratios include Debt-to-Equity and Debt-to-Assets.
Coverage Ratios, on the other hand, evaluate a company’s ability to meet its financial obligations, such as interest payments. Examples include the Interest Coverage Ratio, which compares cash flow to interest expenses, highlighting debt-servicing capacity.
| Other topics you might find interesting | |||
| Current Ratio | Cash Ratio | Treynor Ratio | Operating Ratio |
| Quick Ratio | Expense Ratio | Liquidity Coverage Ratio | Solvency Ratio |
| Risk Reward Ratio | Profitability Ratio | Gearing Ratio | Coverage Ratio |
What is the role of leverage ratios in loan covenants?
Leverage ratios play a critical role in loan covenants, which are agreements between lenders and borrowers that set certain financial conditions. Lenders use leverage ratios, such as Debt-to-Equity or Debt-to-Assets, to assess and limit the amount of debt a borrower can take on. By setting maximum thresholds for these ratios, loan covenants protect lenders from excessive risk by ensuring that the company maintains a healthy balance between debt and equity.
If a company exceeds the leverage limits specified in the covenants, it may be in breach of the agreement, which can trigger penalties, higher interest rates, or even a demand for immediate loan repayment. Thus, leverage ratios ensure that borrowers do not overextend their debt capacity, helping safeguard the financial health of both the lender and the borrower.
What are the risks of high operating leverage and high financial leverage?
Leverage, while capable of magnifying profits, also magnifies risks. A business with both high operating and financial leverage faces significant challenges. High operating leverage implies a company with high fixed costs and low sales, making it vulnerable to even minor revenue declines. This can lead to insufficient income to cover expenses and potentially result in losses. Conversely, high financial leverage occurs when the return on investment (ROI) falls short of the interest paid on loans. This erodes profitability and negatively impacts earnings per share, making the company financially unstable.
Key takeaways
- A leverage ratio measures the level of debt in a company relative to various other metrics like its cash flow, assets and revenue.
- It tells you if a company has the financial capability required to meet its debts and liabilities without defaulting on them.
- Different leverage ratios can be used to assess this aspect of a company’s financial strength.
Common leverage ratios include debt-to-assets ratio, debt-to-equity ratio and debt-to-capital ratio.
Conclusion
The set of leverage ratios discussed in this article are only some of the various indicators and metrics that you need to evaluate before investing in a company. Performing this kind of analysis on every company you are interested in can be tedious and prone to errors. Here is where investing in mutual funds can be a more effective alternative.
Mutual fund schemes give you the advantage of professional fund management and easy diversification. What’s more, on the Bajaj Finserv Mutual Fund Platform, you can compare mutual funds, filter them based on different criteria and choose from over 1,000+ different options. You can even use the free mutual fund calculator available online to finetune your investment decisions.
