Leverage Ratios
It determine the extent of debt a company uses to finance its operations.
What are Leverage Ratios?
Leverage ratios determine the extent of debt a company uses to finance its operations. The company might use debt to finance its working capital needs or for purchasing assets and long-term needs.
It is a common way to know how much debt the company has employed. It is often compared with other financial metrics of a company, like assets, equity, total capital, cash flow, etc.
One can gain a comprehensive understanding of the company's financial structure by assessing the proportion of debt in relation to these metrics.
It helps creditors and investors assess a firm's ability to meet its financial obligations. Whenever a company raises capital through debt, it creates a financial obligation to pay the interest and principal amounts at maturity.
If a firm faces challenges in generating sufficient cash flows and consistently relies on debt, it may signal increased risk. This situation could lead to default and bankruptcy if the firm struggles to meet its fixed obligations.
Creditors and investors want to know the firm's ability to repay the debt, and thus, based on this criteria, they decide whether they would invest in a business or not. Therefore, these leverage ratios can help the investors assess the firm's risk.
A high-levered firm can be both risky and beneficial. If the company is earning enough profits, leverage is beneficial and can help grow the firm's income.
On the other hand, if the company is not earning enough, there might be a chance of default on its payment, making leverage a risky option. Therefore, investors and creditors must carefully examine the leverage ratios to make investment decisions.
Key Takeaways
- The leverage ratio indicates the amount of debt taken to finance the business's daily operations.
- Leverage can be both risky and beneficial.
- Investors generally consider a high leverage ratio risky.
- The most commonly used leverage ratios are debt-to-equity, debt-to-total capital, debt-to-total assets, and debt-to-EBITDA.
Importance of Leverage Ratios
Leverage ratios help measure the amount of debt employed concerning other financial parameters like equity, total assets, profits, etc. It evaluates the risk of a company.
Following are some of the key reasons why leverage ratios are important:
1. Risk Assessment
Leverage ratios help measure a company's financial risk. A high leverage ratio determines high debt and higher risk. As debt comes with the scheduled interest payments, any default here may lead to the company being bankrupt.
2. Investor Confidence
Leverage ratios are one of the important tools that help investors analyze the riskiness of the business. A business with a high leverage ratio may be unattractive to investors because of the high debt component and the possibility of default in payments.
Note
A company with a comparatively low leverage ratio can be attractive to customers.
A company with a high leverage ratio has high debt and higher interest payments, reducing the profits of the company. Using these ratios, investors analyze how efficiently a company uses debt to generate more returns.
Creditors or lenders, before providing credit to businesses, always check a firm's creditworthiness. The leverage ratio can indicate the level of risk in a business.
If a company defaults on interest payments when the leverage ratio is high, it becomes difficult for them to acquire funds.
5. Management Efficiency
The leverage ratio assesses how efficiently the management has allocated the capital in the company. A good capital structure may have a balance of both equity and debt. However, a high leverage ratio may indicate a high use of debt, increasing the company's risk.
6. Industry Benchmarking
The leverage ratio assists in comparing a company’s financial structure with other companies within the same industry.
Note
A comparison can help understand whether a company’s capital structure is within the set standard of industry norms or differs from it.
7. Regulatory Compliance
Regulatory authorities generally set requirements for the leverage ratios to ensure stability and continuity.
For example, banks need to maintain certain capital requirements, including leverage ratio; companies also have debt covenants that specify leverage ratio requirements. Complying with such requirements is necessary for the financial institutions' overall stability.
Types of leverages
Leverage is the amount borrowed to increase profitability, increase return on equity, acquire new assets, or raise funds for the company.
However, it can also lead to more risk if the company cannot generate enough cash flows, resulting in a default in interest and principal amount payment.
There are two types of leverages:
1. Operating leverage
It measures how much a company has the proportion of fixed cost compared to variable cost. A company with more fixed costs is considered to have high operating leverage. A small change in sales volume can result in a large change in earnings and return on investments.
It tells us about the firm's business risk. Operating leverage can be negative when the high fixed cost is not able to be covered up by the earnings of the firm.
Operating leverage = Contribution/ EBIT
Here,
- Contribution = Sales - Variable Cost
- EBIT = Contribution - Fixed Cost
2. Financial leverage
It means when a company wishes to use the debt to finance its operations. Using financial leverage can be beneficial as it helps increase earnings per share and returns on equity, provided that the profits earned are greater than the interest paid on loans.
It measures the financial risk of the company. However, high financial leverage is also considered risky if the company does not have enough cash flows, leading to default in interest and principal amount payment, often resulting in bankruptcy.
Financial leverage = EBIT/ EBIT- Financial Charge = EBIT/ (EBIT - Int) = EBIT/ PBT
Here,
- EBIT = Earnings Before Interest and Taxes
- Financial Charge = Interest payments
List of common leverage ratios
Following are the most commonly used leverage ratios, which tell us about the amount of debt used in the company against different financial parameters like total assets, total capital, equity, and earnings of the company.
1. Debt to equity ratio
It represents how much debt a company holds compared to its shareholders’ equity. It is calculated by dividing total liabilities by shareholders’ equity.
D/E Ratio = Total Liabilities/ Shareholder’s Equity
Liabilities here are the total liabilities that are mentioned in the balance sheet.
Shareholder’s Equity (Net Assets)= Assets - Liabilities
A higher D/E ratio symbolizes high risk. The company is using more debt to finance its daily operations. If a company does not have enough cash inflows, it might default on its repayment, leading to bankruptcy.
A lower D/E ratio shows that the company uses its assets rather than borrowings. The company is using shareholder’s equity to finance the business's operations.
2. Debt to total capital
This ratio measures the proportion of debt employed concerning total capital in the business. It is calculated by dividing debt by total capital.
Debt-to-capital Ratio = Debt/ Total Capital
Here,
- Debt = Short-term debt + Long-term Debt
- Total Capital = Shareholder’s Equity + Debt
A higher Debt-to-Capital ratio signifies high risk. It means that the company is funded more by equity than debt. More debt can lead to default in its interest payment. Therefore, investors would avoid investing in a company with high risk.
3. Debt to total assets
It measures the amount of debt needed to finance the firm’s total assets. It is calculated by dividing debt by total assets.
Debt-to-Total Assets = Total Debt/ Total Assets
Here,
- Total Debt = Short-term Debt + Long-term Debt
- Total Assets = Current Assets + Non-Current Assets
A ratio greater than 1 signifies that most assets are funded by debt rather than equity. It implies that there are more liabilities compared to equity.
A higher debt ratio shows that a company is at high risk. More debt will likely make businesses default on their interest payments, thus leading to bankruptcy.
Conversely, a ratio lower than one proves that the assets of a business are funded more through equity than debt and have a low-risk profile.
4. Debt to EBITDA
This ratio measures the income earned to pay the debt. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is calculated by dividing debt by EBITDA.
Debt-to-EBITDA = Total Debt/ EBITDA
Credit rating firms use this ratio to determine the creditworthiness of a business. A high Debt EBITDA ratio indicates that a business is at high risk and can default in its interest payment.
Interpretation of Leverage Ratios
Debt is an important component of raising capital for a company. There should be an optimal mix of debt and equity in an organization.
Having too much debt can be risky if the company does not have enough cash flows for the obligatory interest and principal payment.
Leverage ratios help measure the risk associated with the company's debt amount. High leverage indicates that business might be risky, but it also provides benefits.
Using leverage can be beneficial when the firm is earning profits, increasing the return on equity for investors. On the other hand, using more leverage can also prove risky if the firm cannot earn enough profits and thus will be at a higher risk of default than a less leveraged firm.
Different leverage ratios interpret different things, such as:
- The debt-to-equity ratio tells us the debt and equity ratio employed in the organization.
- The debt-to-capital ratio helps in analyzing how much debt is employed in comparison to the total capital, i.e., debt & equity in the firm.
- The debt-to-assets ratio signifies the debt used by a company to source its assets. It helps in making better investment decisions.
- The debt-to-EBITDA ratio interprets the debt the company has in comparison to the earnings of the company before paying out any interest, taxes, depreciation, and amortization charges.
Leverage ratio example
XYZ is running a dairy business, and the following is the important financial information about his business. Given below is a solved example of leverage ratios:
| Particulars | Amount ( $ in Millions) |
|---|---|
| Debt | 30 |
| Equity | 70 |
| Assets | 50 |
| EBITDA | 10 |
| Depreciation | 5 |
All the information required to solve the ratios is mentioned in the question. Hence, we need just to put the values in the formula to calculate the leverage ratios.
D/E Ratio = Total Liabilities/ Shareholder’s Equity
= 30/70 = 0.4286
Debt-to-capital Ratio = Debt/ Capital
= 30/ 100 = 0.3
Total Capital= Debt+Equity = 30+70= 100
Debt-to-Total Assets = Total Debt/ Total Assets
= 30/ 50 = 0.6
This ratio indicates that 60% of the company's total assets are funded by debt.
Debt-to-EBITDA = Total Debt/ EBITDA
= 30/ 10 = 3
A Debt-to-EBITDA ratio of less than 3 is generally acceptable, implying that the company has enough profit to pay its debt. The lower the ratio, the lesser the chance of any default.
These leverage ratios should be evaluated compared to industry benchmarks to assess whether the firm's risk profile aligns with its peers.
Leverage Ratios FAQs
Leverage indicates the amount of debt the company raises to increase its earnings per share and return on equity. It multiplies the company’s profitability. However, using too much leverage can be risky, too, as it may lead to a default in payment by the company, resulting in bankruptcy.
There are four main types of leverage ratios, and high leverage ratios indicate that a firm is risky and uses more debt for business operations.
However, these ratios are compared with other companies within the same industries to conclude the company's riskiness.
The most common leverage ratios are used to determine the extent of debt a company uses to finance its operations. Debt is measured against various financial metrics like total assets, EBITDA, total capital, etc.
- The debt-to-equity ratio tells us the debt and equity ratio employed in the organization.
- Debt to capital helps analyze how much debt is employed compared to the total capital, i.e., debt & equity in the firm.
- Debt to assets signifies the debt used by a company to source the assets of the company. It helps in making better investment decisions.
- Debt to EBITDA interprets the debt the company has in comparison to the earnings of the company before paying out any interest, taxes, depreciation, and amortization charges.
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