What is leverage ratio?

Leverage ratio is an indicator of a company's financial health. It helps investors in assessing how much debt is used to fund the company’s operations. Hence leverage ratio is a crucial tool in fundamental analysis of stocks. 

So, what does a leverage ratio mean and how is it calculated? Here we take a look at the leverage ratio definition in more detail. 

Key points

What is a leverage ratio?

Leverage ratio is a financial metric that helps in evaluating a company’s ability to meet its long-term debt obligations.

Businesses frequently use a combination of debt and equity to finance their operations, whether to build a new factory or purchase new machinery.

The leverage ratio is important for investors because it indicates the amount of debt a company incurs and whether it poses a risk. The ratio will show how much of the company's capital is derived from loans and whether the company can repay them.

Different leverage ratios explained

There are several leverage ratios that can be used by investors. The most common leverage ratios according to Corporate Finance Institute are:

• Debt-to-assets ratio 

The debt-to-assets ratio determines to what extent the business operations are funded by debt. Debt-to-assets ratio is calculated by dividing total debt by total assets. For example, if a company has a total debt of $50bn and a total asset of $30bn, the debt-to-asset ratio would be 0.60.

• Debt-to-equity ratio 

Debt-to-equity ratio indicates how much a company relies on debt to fund its operations as opposed to using its own assets. The ratio can be calculated by dividing the firm’s liabilities by its shareholder equity. 

A company with a higher debt-to-equity ratio is considered riskier because it depends heavily on debt financing to expand its business. Higher debts require the company to repay or refinance them. Debts also have interest costs that can't be avoided. If the company fails to make a debt payment, the value of its stock may be reduced.

• Debt-to-capital ratio 

The ratio can determine a company's ability to survive downturns by comparing its debt to available capital. It is calculated by dividing total debt by the total capital, which amounts to total debt plus total shareholders’ equity.

Debt-to-capital ratio can be a useful indicator for avoiding businesses that may have liquidity issues. The higher the debt-to-capital ratio, the greater the risk of default, as liabilities may affect company's operations.

• Debt-to-EBITDA ratio 

Debt-to-EBITDA calculates the amount of revenue earned and available to repay the debt before accounting for interest, taxes, depreciation, and amortisation (EBITDA). It is calculated by dividing total debt by EBITDA.

• Asset-to-Equity Ratio 

The asset-to-equity ratio indicates how much of a company's assets are supported by shareholders. A low asset-to-equity ratio shows that a company's operations are funded by a low amount of debt and a higher proportion of investor funding. The ratio is calculated by dividing total assets by total equity.

How does a leverage ratio work?

A sustainable level of leverage or debt is good for shareholders as it means a company uses less of their equity to fund operations. As a result, the business can raise the return on equity for existing shareholders. 

When the leverage exceeds the company's ability to repay it, it becomes risky. Leverage ratios work as risk indicators because a borrower may face a risk of filing for bankruptcy if the company fails to repay debt on time.

For a prospective lender, leverage ratios are part of analysis tools to decide whether to lend money to a business. However, leverage ratios alone are insufficient as a reason for a lending decision. Lenders must also review other information, including income statements, cash flow data, and the company’s budget.

Types of leverage

According to the Corporate Finance Institute, there are three types of leverage ratio.

Operating leverage

An operating leverage ratio is the proportion or ratio of fixed costs to variable costs. A company with high operating leverage has a high percentage of fixed costs in its operations. It indicates that is a capital-intensive company. 

Financial leverage

A financial leverage ratio is the amount of debt that a company has used or will use to finance its business operations. By using borrowed funds instead of equity funds, a company can substantially improve its return on equity (ROI) and earnings per share (EPS). 

However, it can work under the condition that the increase in earnings exceeds the loan’s interest. Excessive borrowing can cause default and bankruptcy. 

Combined leverage

A combined leverage ratio is the use of both operating and financial leverage. When looking at the balance sheet and income statement, for instance, operating leverage affects the upper half of the statement through operating income, whereas financial leverage influences the remaining part, where EPS can be evaluated.

Leverage ratios examples

To illustrate how to calculate a leverage ratio, let’s look at an example. Let’s imagine that a business has $20,000 in equity, $50,000 in assets and $15,000 in debt. 

• Debt to equity = Debt / Equity

$15,000 / $20,000 = 0.75. It means the firm borrows 75 cents for every $1 equity

• Debt to capital = Debt / Capital

$12,000 / ($15,000 + $20,000) = 0.285

Final thoughts

Leverage ratios can be used to evaluate a company’s financial health looking at its ability to service its debts. It can be useful for investors when conducting fundamental analysis on a stock. Combined with other tools, leverage ratios can reveal the level of risk for the business to file a bankruptcy.

Note, however, that leverage ratios on their own shouldn’t be used as a substitute for your own research. Always conduct proper due diligence looking at a wide range of tools and valuation metrics.

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