Leverage Ratio

We are all working in a competitive environment, hence every industry and business often needs debt to expand their operations, improve efficiency, and make investments in new projects. Thus, the leverage ratio plays a vital role by providing a clear idea of whether the company is wisely handling its debt or overburdened with risk. It is a powerful financial instrument that calculates how much a company depends on debt despite its own equity or assets. This financial instrument helps investors, creditors, stakeholders, and financial analysts to calculate the company’s ability to fulfil the financial obligations and other managerial risks. A good financial leverage ratio signifies a balanced financial structure, whereas a greater value signals a state of being insolvent.

What is Leverage?

Leverage is a process of borrowing money to generate the potential revenue on an investment. It is the amount of borrowed money the company has in its financial structure. When a company has more debt in its financial structure than the average part of its industry, it is considered highly leveraged.

Types of Leverage

There are three major types of leverage: Financial Leverage, Operating Leverage, and Combined Leverage.

1. Financial Leverage:

It is the amount of borrowed funds a business has gained. In the balance report, the financial leverage shows a relationship with the payables shown on the RHS of the report

To find the amount of debt the business has following financial leverage formula is used

Financial Leverage Ratio = Average Total Assets/Average Total Equity

2. Operating Leverage:

It represents how fixed and variable costs affect the cost of production and selling of goods or services. As the fixed assets do not affect output production, the fixed asset costs are constant and hence must be paid regardless of business performance

On the contrary, variable costs vary according to the output production

Operating Leverage = Fixed CostsVariable Costs

3. Combined Leverage:

It shows the total risk for a business

It represents the total effect of financial leverage and operating leverage on the company’s current financial health

Combined Leverage = Degree of financial leverage × Degree of operating leverage

What is Leverage Ratio?

This is a type of calculation that can be used to compare a company’s borrowed funds and assets. It can also be used to calculate the amount of funds in the form of debt and loans, and to find the company’s capability to fulfil its liabilities.

Finance, economics, and business are some sectors in which this ratio is widely used. The company must know the pending amount of debt, as it helps in calculating whether it can be paid off or not.

Leverage Ratio Formula

1. Debt-to-Equity Ratio = Total Debt/Total Equity

It represents the proportion of debt financed as compared to the company’s equity

2. Debt-to-Asset Ratio = Total Debt/Total Assets

It calculates the amount of company assets that are financed by debt

3. Debt-to-EBITDA Ratio= Total Debt/EBITDA

This ratio compares the company’s total debt to its earnings before interest, taxes, depreciation, and amortization

4. Interest Coverage Ratio= Earning Before Interest and Taxes/Interest Expense

The interest coverage ratio determines the company’s ability to repay its debt obligations

Types of Leverage Ratios

There are various types as follows:

1. Debt-to-Equity Ratio

Debt-to-Equity ratio is also known as financial leverage ratio.

Debt-to-Equity Ratio = Total Debt/Total Equity

2. Equity Multiplier:

Equity multiplier is calculated based on the initial equity contribution of the investor to the total cash inflow during the holding period.

Equity Multiplier = Total Assets/Total Equity

3. Debt-to-Capitalization Ratio:

Debt-to-Capitalization ratio calculates the total amount of borrowed funds in a company’s financial modeling structure.

Debt-to-Capital Ratio = Short-term Debt +Long-term Debt/Short-term Debt + Long-term Debt + Stakeholder’s Equity

4. Degree of Financial Leverage:

financial leverage ratio use to calculate the change in earnings per share in comparison with the change in operating return of a company.

Degree of Financial Leverage = % Earning-Per-Share% Earning Before Interest and Tax

5. Consumer Leverage Ratio

This ratio is used to calculate the amount of debt an average US individual has in comparison to net income. Some financial analysts claimed that the sudden jump in consumer debt has been linked to both higher corporate earnings and a major cause for recession.

Consumer Leverage Ratio = Total Household debt Disposable personal income

6. Debt-to-Capital Ratio

The debt-to-capital ratio shows the amount of a company’s total capital obtained from debt in comparison to equity. It is measure by dividing total borrow funds, i.e, debt, by the sum of both total debt and stakeholders’ equity.

Debt-to-Capital Ratio = Total Debt/Total Debt + Stakeholders’ Equity

The higher ratio indicates higher risk; here, the company will struggle to pay off debt. Additionally debt-to-capital ratio varies from industry to industry as they depend more on debt than others.

7. Debt-to-EBITDA Leverage Ratio

The ratio calculates the amount of revenue generated by a company and income available to pay off debt before interest, taxes, depreciation, and amortization expenses. It is generally use by the credit agencies to determine the default risk. It measures the possibility that a company may fail to repay its debt. The ratio determine how many years of EBITDA would be need to repay all its debt. The ratio greater than 3.0 depicts an alarming risk, while it can vary by industry.

Debt-to-EBITDA leverage ratio = Long-term Debt + Short-term Debt/EBITDA

EBITDA: Earnings before interest, taxes, depreciation, and amortization.

8. Debt-to-EBITDAX Ratio

In debt-to-EBITDAX ratio, EBITDAX stands for earnings before interest, taxes, depreciation, amortization, and exploration costs. It has similarities with the EBITDA ratio except for exploration costs, which are generally a common expense for oil and gas companies.

Debt-to-EBITDAX ratio calculates debt against EBITDAX. The ratio is used to stabilize various accounting methods, such as the full cost method vs. the successful efforts method. The remaining non-cash expenses are added in impairments and deferred taxes.

9. Interest Coverage Ratio

The interest coverage ratio is calculated to find out how much a company is capable of paying interest on debt. The calculation is done by dividing the earnings before interest and taxes, or operating income by interest expenses.

Interest coverage ratio = Earnings Before Interest and Taxes/Interest Expenses

A greater ratio value represents greater capability to pay interest on debt. Generally, a ratio of 3.0 is consider good, but it depends on the industry.

10. Fixed- Charge Coverage

Fixed-charge coverage ratio, also known as times interest earned (TIE), is another form of interest coverage ratio. It indicates how a company can easily pay off its interest on debts by calculating the fixed-charge coverage ratio.

It is calculated by dividing earnings before interest and taxes by interest expenses. The higher results of times interest earned show the company is in a better position to pay interest on debt.

Is Leverage Good or Bad?

Leverage is not considered bad when a company is generating potential income, repayments are made properly, and more debt is taken to make appropriate advantage of revenue opportunities from the market.

However, when the company is generating low income, a highly leveraged business may also lag behind on debt repayments and might not get more funds to stay afloat, so the leverage is considered bad.

Debt-to-equity ratio and debt-to-total asset ratio is the two types of ratios use to measure a company’s leverage.

Example: The two companies are working in the same industry, having assets or property of $ 200,000.

Company X has total debt of $50,000 and total investors’ equity of $150,000

Then debt-to-equity ratio is:$50,000/$150,000 = 1:3 or 0.33:1So, for each dollar the company has borrowed, investors have offered $3.

Its debt-to-asset ratio is:$50,000/$200,000= 25%Its financial structure is 25% debt and 75% equity.

Company Y has total debt of $150,000 and total investors’ equity of $50,000

Then debt-to-equity ratio is:$150,000/$50,000 = 3:1So, for each dollar offered by investors, the company has borrowed $3.

Its debt-to-asset ratio is:$150,000/$200,000 = 75%Its financial structure is 75% debt and 25% equity.

Here, company Y is more leveraged than company X. Company Y will perform more efficiently when the market is at its peak, but during the market downfall, it has to struggle. A slow growth over a long term will make the company Y insolvent.

What is Leverage in Financial Management?

The term leverage means to borrow funds, called debt, for a company and use it to raise the potential income on investment or to purchase assets. These debt funds are used to improve the operations, finance the company projects, or purchase more assets for the company if they are not capable of buying only with their own equity, thus increasing their buying capacity and potential income.

But, in some cases, leverage might increase the risk when the borrowing company’s investment income is low and therefore it is not capable of repaying the debt, thereby decreasing the investment success and increasing the loss of the company.

What is Financial Leverage?

Financial leverage is a procedure in which a company takes a loan or borrows funds to increase its future income or earnings exceeding its debt obligations. In this process, the company makes use of its liabilities to generate income or earnings, even at risk.

Leverage is generally use by a company when it makes an investment in its own company for the purpose of development, acquisition, and other development practices.

It is a type of financial strategy where a company makes use of several securities to generate the expected income on investment.

Importance of Financial Leverage

It plays a major role in generating market opportunities for shareholders and industries. Along with many opportunities, financial leverage brings some risk for the shareholders, as leverage also increases the chance of losses during market downfall. Certainly, leverage generates more debt as compared to potential return if market downfall lasts for a longer period.

Working Process of Financial Leverage

Financial leverage is when investors or businesses use debt to increase returns, finance projects, and improve operations. This type of leverage is generally use to raise the business equity base or net asset value.

Stakeholders use leverage to substantially raise the income that is offers on an investment. They use various instruments such as options, margin accounts, and futures to leverage their investment

Businesses make use of leverage to finance their projects, operations, and to purchase assets. This gives an advantage of using debt despite offering stocks to increase capital

Stakeholders can access leverage indirectly by investing in companies that make use of leverage in the basic operations of their business like developing or financing operations without increasing their expenditure. Such as developing or financing operations without increasing their expenditure

The outcome of financial leverage is to increase the potential income from an investment project. Simultaneously, it raises the risk if the investment does not increase the return, which indicates that the debt is more than equity, by comparing the company’s net property or investments as highly leveraged

What is the Financial Leverage Ratio?

A financial leverage ratio known as solvency ratio, uses a company’s balance sheet to calculate the degree to which a company utilizes its debts to purchase assets and perform operations. Some financial leverage ratios involve:

Debt-to-equity ratio relates a company’s total debt to its stakeholder equity

The debt-to-asset ratio measures the ratio of assets purchased using debt

These financial leverage ratios evaluate a company’s financial risk. A high ratio value indicates greater dependency on debt and thus increases financial risk for the company

Financial Leverage Formula

1. The ideal financial leverage formula is:

Debt-to-Equity Ratio = Total Debt/Total Equity

2. Other common formulas are:

Equity Multiplier = Total Assets/Total Equity

3. Debt-to-Capital Ratio = Total Debt/Total Debt + Total Equity

Conclusion

Financial leverage ratio is not merely numbers; they are the financial figures that indicate a company’s strength, risk management ability, and the power to generate potential income. Generally, Industries that properly manage and maintain the balance between debt and equity gain financial solvency. Whereas it is important to note that a good financial leverage ratio varies by industry size and market size. For example, asset-intensive industries like manufacturing, energy, transportation, telecommunications, pharmaceuticals, and mining may operate with a greater ratio value as compared to technological firms. Some metrics which is being consider for comparison are industry, company size, and the economic condition of the industry.