Leverage Ratios
It determine the extent of debt a company uses to finance its operations.
What are Leverage Ratios?
A leverage ratio is a type of financial metric used to determine to what extent a company uses debt to finance its operations.
Leverage ratios reveal information about a firm’s capital structure to investors, allowing them to understand how a company finances its activities and how likely they are to cover its financial obligations.
Leverage ratios are some of the most commonly used financial metrics when looking at or analyzing a company.
- A leverage ratio is a type of financial metric used to determine to what extent a company uses debt to finance its operations.
- Some of the most common leverage ratios include debt-to-equity (D/E), debt-to-assets (D/A), debt-to-capital (D/C), and debt-to-EBITDA.
- Financial analysts and investors use leverage ratios to find the level of risk associated with a company and whether it will be able to cover its financial obligations.
- A firm’s leverage ratios can be compared to its peers or industry benchmarks to estimate its risk profile.
Understanding Leverage Ratios
A company’s capital can come in one of two forms: equity–money exchanged for ownership in the company–or debt–money borrowed from others in exchange for an interest payment.
A company’s capital structure is the distribution of equity and debt that makes up its finances. Some companies may employ more debt, and some may use more equity to finance their operations. Using leverage ratios is a good way to determine which is the case.
Knowing how much debt a company has taken on is crucial to investors and creditors. Whenever a company takes out a loan, it creates the financial obligation to pay the lender recurring interest payments and the principal amounts at maturity.
If a company faces substantial challenges in generating cash flow and consistently relies on debt to finance its operations, this indicates a certain level of risk for the company. Companies that take on debt that they are not able to pay back may have to default on their loans and declare bankruptcy.
Investors and creditors are, therefore, interested in knowing how much debt a company has taken on so they can assess the degree of risk involved in investing in or lending to that company.
For a company that is enjoying consistent income growth and generating stable cash flows, leverage can, despite the risk involved, help the company grow and increase its income. On the other hand, leverage can be a problem for companies facing financial difficulties.
Investors will use the leverage ratios to examine a company’s capital structure and how much debt it has taken on. Using this information, they can assess the risk involved in the company and will make an informed decision about whether or not to invest in it.
Types of leverage ratios
There are many different leverage ratios, each involving different financial metrics such as debt, equity, and assets. However, as their name suggests, leverage ratios are a ratio of one metric over another.
The list of a few different leverage ratios below is by no means exhaustive, but it covers the ratios most commonly used by finance professionals.
Debt-to-equity (D/E) ratio
Generally, the debt-to-equity (D/E) ratio represents how much debt a company holds relative to its total shareholder’s equity.
However, the D/E ratio can be calculated in one of three ways. First, it can be calculated simply as debt divided by equity, which considers only the liabilities labeled as “debt” on the balance sheet.
D/E Ratio = Total Debt/ Shareholder's Equity
Secondly, the value in the numerator can be broadened to include not just debt but total liabilities, which also includes unearned revenue and other accrual accounts.
D/E Ratio = Total Liabilities/ Shareholder's Equity
Although this isn’t used as often, the D/E ratio can also be calculated using only long-term debt, which excludes both short-term debt and the current portion of long-term debt.
D/E Ratio = Long-Term Debt/ Shareholder's Equity
The debt-to-equity ratio is one of the most straightforward ways of analyzing a company’s capital structure.
A ratio higher than one means that the proportion of debt used to finance assets is higher than the proportion of equity.
The higher a company’s debt-to-equity ratio, the higher risk it involves. The more debt a company takes on, the higher the chance it will be unable to pay off its debt. If this happens, the company will have to default on its loans, leading to bankruptcy.
Debt-to-assets (D/A) ratio
The debt-to-assets (D/A) ratio, also known simply as the debt ratio, measures how much debt is needed to finance the company’s total assets.
D/A Ratio = Total Debt/ Total Assets
Where total debt is calculated by adding short-term and long-term debt, and total assets by adding current and noncurrent assets.
The D/A ratio is another simple measure of a company’s capital structure, as total assets equal total liabilities plus shareholders’ equity. Therefore, the D/A ratio will simply tell us the proportion of the company’s assets financed through debt instead of equity.
For instance, a ratio of 0 would mean that the company has no debt, whereas a ratio of 0.5 means that the company’s assets are financed by equal parts debt and equity.
A ratio of higher than 1 would mean that the company is insolvent since it has more liabilities than assets it can use to pay down those liabilities.
One problem with the D/A ratio is that total assets are also considered non-financial liabilities. Therefore, an increase in non-financial liabilities would decrease the ratio despite not being relevant to the firm’s capital structure.
Debt-to-capital (D/C) ratio
The D/C (debt-to-capital) ratio, also known as the capitalization ratio, is very similar to the D/E and D/A ratios and is perhaps the simplest measure of a firm’s capital structure.
The D/C ratio is calculated by dividing the total debt taken on by the firm by the firm’s total debt plus equity.
D/C Ratio = Total Debt/ (Total Debt + Shareholder's Equity)
The D/C ratio represents the proportion of the company’s capital structure that consists of debt.
For example, a ratio of 0 means that a firm has no debt, whereas a ratio of 0.5 means that the firm’s capital structure comprises equal parts debt and equity.
Once again, the higher the capitalization ratio, the more risk the company is taking, as the chance of defaulting on its debts and declaring bankruptcy is higher.
Debt-to-EBITDA ratio
The debt-to-EBITDA ratio is another common ratio used to determine a company’s ability to pay down its debt.
Debt/ EBITDA Ratio = Total Debt/ EBITDA
Sometimes, the net debt–to–EBITDA ratio is used, which uses net debt instead of total debt as its numerator. Net debt is calculated by subtracting cash and cash equivalents from total debt.
Net Debt/ EBITDA Ratio = Net Debt/ EBITDA
= (Total Debt - Cash and Cash Equivalents)/ EBITDA
Since EBITDA is one of the most accurate metrics for a company’s real cash earnings, knowing how high a company’s EBITDA is compared to its debt can help determine how capable it is of paying down that debt (i.e., how many years it would take to pay off the debt).
The lower the debt-to-EBITDA ratio, the less risk there is for the company. Ultimately, however, different industries require different amounts of leverage, and any company should be compared to its competitors to determine whether it’s taking on a healthy amount of debt.
Asset-to-equity ratio
The asset-to-equity ratio, also known as the equity multiplier, is another leverage ratio. In this case, total assets are divided by the company’s shareholders’ equity.
Equity Multiplier = Total Assets/ Shareholder's Equity
A ratio of two means the company’s assets are financed with equal parts debt and equity. A ratio lower than two signifies that the company is financed mostly with equity, and a ratio higher than two means that the company is financed mostly with debt.
The equity multiplier is an important component of the DuPont model for calculating return on equity.
Degree of financial leverage
The degree of financial leverage (DFL) is a metric that determines the sensitivity of the company’s net income (or earnings per share, which is net income divided by shares outstanding) to changes in operating income (EBIT).
DFL = % Change in Net Income/ % Change in EBIT
=% Change in Earnings Per Share/ % Change in EBIT
Since interest is a fixed expense, taking on more debt will cause a proportionally larger increase in income and earnings per share. Therefore, a higher DFL reflects a higher amount of financial leverage, and a lower DFL reflects a lower amount of financial leverage.
A high DFL is good when the operating income (EBIT) is increasing since net income also rises. However, a high degree of financial leverage can be a problem if EBIT is under pressure. Therefore, a higher DFL signifies that more risk is involved in the company.
Interest coverage ratio
Much like the debt-to-EBITDA ratio, which determines a company's ability to pay off its loans, the interest coverage ratio measures a company's ability to pay interest on its loans.
The interest coverage ratio is calculated by dividing the operating income (EBIT) by the interest expense.
Interest Coverage Ratio = EBIT/ Interest Expense
The higher the numerator is compared to the denominator, the more income a company has that it can use to make its interest payments.
A low-interest coverage ratio signals that a company involves a lot of risks since there is the possibility that it may have to default on its loans. However, what constitutes a high or low-interest coverage ratio will depend from industry to industry.
Leverage Ratio Example
Consider a company with the following characteristics:
| Particular | Amount (Millions of $) |
|---|---|
| Total Debt | 40 |
| Shareholder’s Equity | 90 |
| Total Assets | 70 |
| EBITDA | 20 |
| Depreciation & Amortization | 5 |
| Interest Payment | 5 |
Additionally, assume that a 50% increase in EBIT leads to a 60% increase in net income. This information is enough to calculate all of the different leverage ratios described above.
To calculate the debt-to-equity ratio, we simply divide total debt by shareholder’s equity.
D/E Ratio = Total Debt/ Shareholder's Equity = 40/ 90 ≈ 0.444
To determine the debt-to-assets ratio, we divide total debt by total assets instead.
D/A Ratio = Total Debt/ Total Assets = 40/ 70 ≈ 0.571
The debt-to-capital ratio can be found by dividing total debt by the sum of total debt and shareholder’s equity.
D/A Ratio = Total Debt/ (Total Debt + Shareholder's Equity) =40/ (40+90) =40/ 130 ≈ 0.308
The debt-to-EBITDA ratio is calculated by dividing total debt by EBITDA.
Debt/ EBITDA Ratio = Total Debt/ EBITDA = 40/ 20 = 2
Next, we can compute the asset-to-equity ratio by dividing total assets by shareholder’s equity.
Equity Multiplier = Total Assets/ Shareholder's Equity = 70/ 90 ≈ 0.778
As explained above, the degree of financial leverage is calculated by dividing the percentage change in net income by the percentage change in EBIT.
DFL = % Change in Net Income/ % Change in EBIT = 60%/ 50% = 1.2
Finally, we can find the interest coverage ratio by dividing the company’s EBIT by its income expense. We subtract depreciation and amortization from EBITDA to get the company's EBIT.
EBIT = EBITDA - D&A = 20 - 5 = 15
Interest Coverage Ratio = EBIT/ Interest Expense = 15/ 5 = 3
Leverage Ratios FAQs
Leverage refers to borrowing capital to finance a company or an operation. Also called debt, leverage usually comes in the form of loans, whereby a financial institution lends a borrower a principal amount with a set maturity date and interest rate.
The borrower must repay the principal and all interest payments to the lender by the maturity date.
A leverage ratio is a type of financial metric used to determine to what extent a company uses debt to finance its operations. Some leverage ratios can also be used to determine how capable a company is of paying back its loans.
Leverage ratios are, as the name suggests, calculated by dividing one financial metric by another, and their simplicity makes them a very common tool among finance professionals.
Leverage ratios are used to determine how much debt a company uses to finance its operations and how able it is to pay down that debt.
Using this information, finance professionals can assess the amount of risk and possible reward associated with the company and make an informed decision about whether or not to invest in or lend to it.
The most commonly used ratios are the debt-to-equity (D/E), debt-to-assets (D/A or simply debt ratio), debt-to-capital (D/C or capitalization ratio), and debt-to-EBITDA ratios.
Other commonly used ratios include the asset-to-equity ratio (also known as the equity multiplier), the degree of financial leverage, and the interest coverage ratio.
The formulas for calculating each of the leverage ratios are as follows:
- Debt-to-equity (D/E) ratio = total debt/ shareholder’s equity
- Debt-to-assets (D/A) ratio = total debt/ total assets
- Debt-to-capital (D/C) ratio = total debt/ (total debt + shareholder’s equity)
- Debt-to-EBITDA ratio = total debt/ EBITDA
- Asset-to-equity ratio = total assets/ shareholder’s equity
- Degree of financial leverage = % Change in Net Income/ % Change in EBIT
- Interest coverage ratio = EBIT/ interest expense
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