What is leverage ratio?
Boost your knowledge about the different types of financial leverage ratios, with examples, formulas, and why they’re important to traders on Capital.com.
What are financial leverage ratios?
Financial leverage ratios – sometimes referred to as ‘leverage ratios’ – gauge a company’s creditworthiness by measuring its borrowing relative to its assets, equity and capital.
They combine two core concepts, financial ratios and leverage:
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Financial ratios evaluate a company’s financial health. There are different ratios that measure factors such as liquidity, solvency and profitability.
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Financial leverage is the act of a company borrowing capital, which can increase its exposure to gains or losses.
Traders use financial leverage ratios to assess a company's risk and potential for growth through debt, while analysts evaluate the sustainability of its financial structure and creditors examine these ratios to determine the firm's ability to meet long-term debt obligations.
Commonly used financial leverage ratios include debt-to-equity, debt-to-assets and net leverage ratio.
How do financial leverage ratios work?
Financial leverage ratios compare a company’s outstanding debts with its equity, assets or earnings to determine how reliant it is on borrowing to finance its operations. This ratio helps gauge the company’s risk exposure and its ability to meet financial obligations.
Financial leverage ratios are calculated using current and historical data, including total debt, equity, assets, EBIT and EBITDA. This data is readily available for publicly traded companies, making them useful for traders who want to assess how accurately a company’s stock price reflects its performance over time.
The result of the calculation is expressed as a number or percentage, showing the relationship between debt and other financial metrics.
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Higher financial leverage ratios suggest greater financial risk due to heavy reliance on debt financing.
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Lower financial leverage ratios indicate less financial risk and a more conservative business strategy, due to less dependence on debt.
What are the different types of financial leverage ratios?
There are several financial leverage ratios that provide insight into a company’s borrowing levels and financial risk. Here are a few of the most common types, along with examples, trading strategies and the formulas to calculate them:
Debt-to-asset ratio
The debt-to-asset ratio measures the percentage of a company's assets that are financed by debt, providing insight into the company's overall financial leverage and risk. Traders could use the debt-to-asset ratio to identify highly leveraged companies that might experience greater price volatility, which could be suitable for short-term trading strategies such as day trading.
Calculate the debt-to-asset ratio using this formula:
Debt-to-asset ratio = total debt / total assets
For example, a company has total assets of $12 million and total debt of $5 million. To calculate its debt-to-asset ratio would be $5 million / $12 million = 0.42 or 42%, which means that 42% of the company's assets are financed by debt.
Net leverage ratio
The net leverage ratio – often referred to as ‘net debt-to-EBITDA’ – evaluates a company’s debt levels after accounting for its cash holdings, relative to its EBITDA (earnings before interest, taxes, depreciation and amortisation). Traders may use the net leverage ratio to find shares issued by companies with manageable debt levels, which could be suitable for a swing trading strategy based on fundamental analysis.
Calculate the net leverage ratio using this formula:
Net leverage ratio = (total debt - cash holdings and equivalents) / EBITDA
For example, a company has total debt of $6 million, cash holdings of $2 million and EBITDA of $3 million. To calculate the company’s net leverage ratio would be ($6 million - $2 million) / $3 million = 1.33. This suggests that, after accounting for its cash reserves, the company’s debt is 1.33 times its EBITDA.
Debt-to-EBITDAX ratio
The debt-to-EBITDAX ratio measures a company's ability to pay off its debt using earnings before interest, taxes, depreciation, amortisation and exploration expenses (EBITDAX). This ratio is particularly useful in industries like oil and gas, where exploration costs significantly impact profitability. Traders might use the debt-to-EBITDAX ratio as part of a sector-specific trading strategy, such as trend trading in resource industries.
Calculate the debt-to-EBITDAX using this formula:
Debt-to-EBITDAX = total debt / EBITDAX
For example, a company that operates in an industry with significant exploration costs – such as oil and gas – has total debt of $15 million and EBITDAX of $5 million. The debt-to-EBITDAX ratio is calculated as $15 million / $5 million = 3. This indicates the company’s debt is three times its EBITDAX, showing how leveraged it is relative to its earnings from operations, including exploration expenses.
Debt-to-equity ratio
The debt-to-equity ratio compares a company’s total debt to its shareholders’ equity, indicating how much debt is used to finance the company relative to its equity. Traders could potentially use the debt-to-equity as part of a margin trading strategy, especially when trading companies with higher leverage, as the ratio indicates potential price volatility.
Calculate the debt-to-equity ratio using this formula:
Debt-to-equity ratio = total debt / shareholders' equity
For example, a company has total debt of $8 million and shareholders' equity of $12 million. Its debt-to-equity ratio is calculated as $8 million / $12 million = 0.67. This indicates that for every $1 of equity, the company has $0.67 in debt, reflecting a balanced approach to financing through both debt and equity.
Debt-to-capitalisation ratio
The debt-to-capitalisation ratio represents the extent to which a company uses long-term debt versus equity to finance its assets, providing insight into the company's long-term financial stability. A higher ratio indicates more financial risk due to higher long-term debt obligations, while a lower ratio could mean less financial risk due to a greater reliance on equity financing.
Traders might use the debt-to-capitalisation ratio to target companies with stable long-term financing using a position trading strategy to seek potential long-term gains in the stock market.*
Calculate the debt-to-capitalisation ratio using this formula:
Debt-to-capitalisation ratio = long-term debt / (long-term debt + shareholders’ equity)
For example, a company has long-term debt of $20 million and shareholders' equity of $30 million. Its debt-to-capitalisation ratio would be $20 million / ($20 million + $30 million) = 0.4 or 40%. This means that 40% of the company’s long-term capital is financed through debt.
*Past performance does not guarantee future results.
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