This post may contain affiliate links to products that I recommend and I may earn money or products from companies mentioned in this post. Please check out my disclosure page for more details.
In any business, securing funding for operations, investment, or capital expenditure is a vital part of the business structure and their leverage ratio. Without the capacity for funding from loans, companies would struggle to expand and maintain operations when cash flow is low.
The leverage ratio is a financial measurement of a company’s capital that comes from debt and is a yardstick to determine the ability of a business to meet its financial obligations. There are several different ratios that can be used in this assessment.
Understanding the leverage ratio and how to apply it successfully to give a clear view of a company’s financial landscape is critical for investors or lenders looking to ascertain the level of the financial risk involved.
Why Is The Leverage Ratio Important?
The leverage ratio is one of the primary indicators of how much debt a company has and whether it can pay debt successfully when it becomes due. All companies use a blend of debt and equity for operational finance, and the leverage ratio determines the financial strength. It’s also considered by financial institutions if a business is considering using a revolving credit facility to finance operations.
The leverage ratio can also determine how operating income could be affected by output changes and provides a measure of the business’s operating expenses make-up in terms of debt and equity.
Lenders use leverage ratios to consider whether the company is at risk of falling under bankruptcy protection or whether the business has a solid financial base and would be able to repay loans or lines of credit. For consumers, this is when the proportion of loan balances to loan amount is too high. The same is true for businesses in the form of the financial leverage ratio.
The Five Most Common Types Of Leverage Ratios
There are several kinds of leverage ratios used, and each has a slightly different calculation using various factors based on the company’s financial statements.
There are five common leverage ratios and four coverage ratios.
Common Leverage Ratios
1. Debt-To-Asset Ratio
2. Debt-To-Equity Ratio
3. Debt-To-Capital Ratio
4. Debt-To-EBITDA Ratio
5. Asset-To-Equity Ratio
As you can see, each ratio uses slightly different financial factors to determine the various ratios in the business’s operating economic structure. Let’s take a deeper look at each one, what it means and how to calculate it.
Before that, let’s understand what the numbers mean, a reasonable leverage ratio, and why.
What Constitutes A Good Leverage Ratio
In some instances, like the interest coverage ratio, which will be discussed later, a higher ratio would be better. Still, for the most part, the lower the ratio figure, the better.
- For example, the most common leverage ratio is the debt-to-equity ratio, and in this case, the ratio should be below 1.0.
- A very low ratio of around 0.1 will show that the business had virtually no debt relative to its equity. A ratio of 1.0 indicates that the debt and equity are essentially equal.
- Ideally, a ratio of 0.5 would be considered on the higher side of desirable and shows that the company has double the level of assets compared to liabilities.
Combined with other factors such as the industry it operates in, scale, and maturity, this measurement would give solid insight into the leverage usage in that company.
Now, let’s take a more in-depth look at each ratio, its meaning, and how to calculate it.
Leverage Ratios – What They Mean And How To Calculate Them
For the calculation examples, we will assign the following values to the various factors in the equation.
$10 Million in Assets
$4 Million in Debt
$ 5 Million in Equity
$2 Million in EBITDA
$1 Million in Annual Depreciation expenses
This measures the total debt to the total asset ratio and is calculated by dividing the total debt by the total assets.
As an example, a company has $4M in debt and $10M in assets.
- Thus the calculation is 4M/10M = D/R Ratio of 0,4
As per the above, this ratio falls on the better side of the ratio and shows that the company has slightly more than double the asset value relative to debt.
This measures the total debt to the total equity and is calculated by dividing the debt by the equity.
Using the numbers above, we can determine that the company has $4M in Debt and $5M in Equity.
- So this ratio would be 0.8, calculated as 4M/5M = 0.8, and would be on the more negative side as it is close to the 1.0 level where debt and equity would be equal.
In this case, the equity is 20% higher than the debt.
This ratio determines the level of debt in the capital structure of the business. It is calculated by dividing the total debt by the total capital, with the total capital being calculated as the debt plus the equity.
- Using the numbers above, this company’s debt-to-capital ratio would be calculated as $4m/($4m+$5m)= 4/9 = 0.44, and again, this falls on the favorable side of this equation.
The EBITDA is the Earnings Before Interest, Taxes, Depreciation, And Amortization, and this ratio is calculated by dividing the debt by the EBITDA. This ratio measures the company’s ability to settle incurred debt, and a ratio over three would not be a good reflection.
- With $4M in debt and $2M in EBITDA, the ratio here would be 2 (4M/2M), and this would be an acceptable ratio level.
This ratio is also known as the Equity Multiplier, and although debt is not explicitly referenced in this equation, the assets include the debt.
This company would have an Asset-To-Equity ratio of 2 as the calculation would be $10M assets divided by $5M equity = 10/5 = 2.
Apart from the common leverage ratios above, some other ratios are used to assess a company’s financial stability and leverage.
- Interest Coverage Ratio
The Interest Coverage ratio determines the ability of the business to cover only the interest on its debt and is calculated by dividing the Operating Income by the Interest Expense.
- The number of times over a company could pay its interest costs on debt with operating income is measured by this ratio.
A value of 1.5 is considered as the minimum acceptable level
2. Debt Service Ratio
This measures the business’s ability to pay off all debt, including capital and interest, using its operating income. A value of less than 1 for this ratio would indicate that it cannot service its total debt.
- This is calculated by dividing the Operating Income by The Total Serviceable Debt
3. Cash Coverage Ratio
Similar to the Interest Coverage Ratio, this value measures the capacity of the business to pay its interest expenses with its cash balance. Asset Coverage Ratio compares the company’s annual interest expense with its on-hand cash only.
- This coverage ratio is calculated by dividing the total cash by the total interest expense.
For example, if a company has a $10 Million cash balance and annual interest expense of $500 000, this shows the company can pay this 20 times over.
4. Asset Coverage Ratio
This calculation measures the ability of the company to settle its total debt obligations by liquidating the company assets and is calculated by using the following formula:
- Asset Coverage Ratio = ((Total Assets- Intangible Assets)-(Current liabilities – Short Term debt))/ Total Debt Obligations
For example if a company has the following:
- Total Assets = $ 20 Million
- Intangible Assets = $ 5 Million
- Current Liabilities = $ 2 Million
- Short Term Debt = $ 1 Million
- Total Debt = $ 5 Million
The calculation would then be : ACR = ((20-5)-(2-1)/ 5 = (15)-(1)/5 = 14/5 = 2.8.
This shows that the company would safely settle all debts without liquidating a large percentage of its assets.
The Various Types Of Leverage Ratios
Now that we have looked at the actual ratios, we need to examine the types of leverage used in business to demonstrate how a company uses or utilizes borrowed funds. Knowing outstanding balance vs. principal balance is critical.
The leverage ascertains the level of solvency and the capital structure in a business. While it can be risky to have high leverage within a company’s capital structure, benefits are also involved.
When the business is profitable, then the leverage is amplified, but should profits decline, a deeply leveraged business may risk default than companies with less leveraged structures.
The level of debt or borrowed funds is the cornerstone of this ratio and determines the amount of debt a business would utilize to fund its operations. Using debt to finance operations instead of equity gives the company a better return on equity and share earnings.
- This benefit would be practical only if the return is greater than the interest expense; when loans are used excessively, this increases the risk of default.
This is a ratio that determines the percentage of fixed costs to variable costs. For example, a company with high operational leverage carries most of the fixed costs within its operations.
- This would be a capital-intensive business, and even with minor changes in sales revenue, return on investment would be more significant, as would the increase in earnings.
If demand for the product in the market dropped, the company would be unable to cover its fixed costs from operating earnings. This scenario happens in industries like vehicle manufacturing, where demand for the product may fluctuate.
This is where financial and operating leverage are combined and the balance sheet analysis where the upper level would be influenced by operating income and leverage. In contrast, the lower end of earnings per share is affected by financial leverage.
Let’s now examine how leverage is created through various scenarios.
How Leverage Could Be Created
There are several situations where leverage could be created:
- A business elects to increase the fixed costs to leverage operations. This does not change the business’s capital structure, but the increase in fixed costs would increase operating leverage, increasing or decreasing profits disproportionately relative to income.
- Equity investors decide to take a loan to leverage their investment portfolio (such as options vs. futures).
- An individual purchases a property and elects to borrow funds from a bank or mortgage lender to cover a portion of the cost. Should the property be sold for a profit, then again would be achieved.
- Leverage can be created when a company or another private equity firm opts for an LBO or Leverage Buy-Out.
- When a business looks to finance a new acquisition, possibly through a mergers and acquisitions transaction.
- A company chooses to utilize a cash flow loan based on the overall creditworthiness of the business. These types of loans are mainly only available to larger companies.
- Asset-backed loans create leverage and are standard practice when it comes to PP&E transactions in which a company uses borrowed money to fund the purchase of specific assets. This type of leverage is related to purchasing fixed assets like property, plants, and equipment. Verizon made a sizeable equipment purchase a few years back.
Finally, let’s look at the potential risks involved with high operating and financial leverage.
Which Businesses Have Higher Leverage Ratios
The financial leverage ratio is used to measure the amount of leverage a company has and how it is financing its operations.
The lowest leverage would be represented by low debt-to-equity ratios, as leverage is what increases financial risk. It is also likely that businesses with higher leverage ratios carry more risk than those with lower ratios if they were all financed with similar amounts of leverage.
Traditionally, start-ups will have higher leverage ratios as large portions of their cash flow would be allocated to paying off debt used to launch the business.
Also, any business that has higher production costs tends to have higher debt-to-equity ratios than others.
Capital-intensive industries where significant ongoing infrastructure and maintenance investment are required also lead to higher debt-to-equity ratios. Examples are the oil and gas industry as well as telecommunications.
Bank Financial Leverage Ratios
Banks operate on leverage as a principle of expanding income on a small amount of capital.
The leverage ratio is the relationship between a bank’s equity capital and its total assets. It can be calculated by dividing a bank’s total equity by its total assets.
Leverage Ratio Formula for Banks
The leverage ratio for a bank is calculated by dividing its total equity capital by its total leverage exposure.
The leverage exposure for a bank refers to the amount of risk that the bank imposes on its creditors due to utilizing leverage ratios. In other words, it represents all the debt obligations that have been incurred by the bank and need to be repaid.
So, leverage exposure = (total assets – cash, reserves & treasuries) x average risk-weighted assets where risk-weighted assets = (average total credit exposures + average off-balance sheet exposures) ÷ 2
For example, let’s take an imaginary bank with $10 million in equity and $40 million in assets. The leverage ratio for this bank would be 2, which indicates that the bank is highly leveraged and therefore has a high risk of defaulting on its obligations because it does not have enough equity to absorb potential losses in the event of a downturn in earnings.
People wonder can you make a living by trading Forex with this process? The answer is that it’s a similar leverage process.
How Leverage Applies To Banking:
If we were to use leverage when trading currencies, we would borrow funds from our broker to leverage our position size and increase our trade’s overall profitability and gain.
Imagine if we had $25,000 and wanted to purchase $100,000 worth of XAGUSD (Silver) futures contract.
- At 50:1 leverage factor, we need only a $20,000 margin deposit.
- We can multiply this by another 50 to use $1000 leverage.
- So now, with only a $20,000 deposit, we can trade a massive position of $100,000.
If the market moves in positive favor by even 1 pip, we will have made a nice 50% gain on our initial investment due to leverage. A 5% leverage ratio is an excellent indicator of stable financial leverage for banks.
Risks Of High Financial And Operating Leverage
As with any aspect of business, leverage has both risks and rewards. Knowing these and identifying them is essential to any business’s financial credit and operating structural evaluation.
Any business with high ratios in both operating and financial leverage is significantly at risk. With high operational leverage ratios, it means that there are high operating costs with lower sales volume, resulting in an inability for the company to cover its expenses.
This configuration would result in negative earnings for the company and would not be a favorable outcome.
With high financial leverage ratios, the company’s interest paid on loans exceeds the Return On Investment, significantly reducing profitability and earnings per share.
What is the average leverage ratio of businesses?
The leverage ratio of businesses can differ greatly. The highest leverage ratios are represented by capital-intensive industries requiring significant investments in assets, with debt to equity ratios reaching 110%.
However, leverage ratios will usually average around 30%, as leverage is a high-risk business practice that typically only applies to large corporations that have a market value greater than US$10 billion.
What are the risks involved with using leverage?
Risks involved with using leverage are significant. The use of leverage increases leverage ratios considerably, leading to higher financial risk for businesses if their profit margin is insufficient, resulting in negative earnings. Operational leverage results in additional business costs without any increase or stabilization of sales volume, which would be financially detrimental for most businesses.
When is leverage best used in business?
Leverage is only recommended when a business has low leverage ratios; if the leverage ratio is high, it will cause more risk. Low leverage means that the interest of any debt that might incur is less than or equal to the return on investment of assets, minimizing financial risk.
When should businesses avoid leverage?
Businesses should avoid leverage if their profit margin does not exceed their interest paid on debt, which would result in negative earnings and higher operational risks leading to bankruptcy. Additionally, businesses with high leverage ratios are subject to increased bankruptcy risks due to fluctuations in sales volume.
What are the advantages and disadvantages of using leverage?
The main advantages of using leverage are increased profitability and gain on investments with only a fraction of the required investment. However, leverage can also increase risks and limit business operations and growth if leverage ratios are high enough to reduce profitability and earnings significantly.
Utilizing the leverage ratios to ascertain the financial operating structure and leverage of a business will give a clear picture of financial wellness of the company as well as the future potential.
While leverage ratios are only a part of an overall financial assessment, they provide an accurate insight into its economic structures and viability.