Leverage Ratio

The amount of leverage a business has relative to an asset, equity, or a cash flow metric.

What is Leverage?

Leverage is a strategic approach involving the use of borrowed funds to invest in business operations, such as purchasing an asset that is expected to bring more earnings or gains. It enables gains to be multiplied; however,  there is the risk that leveraging will result in a loss if the borrowing costs exceed the income derived from the use of the asset or if the value of the asset dramatically falls.  A company whose debt is significantly higher than its equity is considered highly leveraged and may be at risk of bankruptcy.

How is Leverage Created?

Leverage is created through various situations:

  • When an individual deals with options, futures, margins or other financial instruments.
  • When a person becomes short of cash savings to purchase a house and opts to borrow funds from a financial institution to cover a portion of the price. If the property is resold at a higher value, a gain is realized.
  • Equity holders or shareholders decide to borrow money to leverage their investments without increasing equity. If there are more gains derived as a result of borrowing, any profits are shared among a smaller base of shareholders and are proportionately bigger.
  • Businesses us fixed cost inputs to leverage their operations. Fixed costs do not change with an increase or decrease in production output, so they tend to result in a larger increase in operating income.

To illustrate:

Hillary has $50,000 cash in her savings account and borrows $100,000 to buy a 2-bedroom house with a selling price and market value of $150,000. If this property increases in value by 25 percent in a year and then is resold, she will make a $37,500 gain from sale (market price is $187,500 less purchase price of $150,000). From the proceeds of sale, the borrowed money will be paid off and the remaining portion will be in Hillary’s possession. By using her own money and borrowed funds, she was able to earn income by selling the property.

What are the Three Types of Leverage?

Operating leverage – pertains to the percentage or ratio of fixed costs to variable costs. It determines the amount of fixed assets (plant and equipment) used by a company. A company that has high operating leverage bears a large amount of fixed costs in its business’s operations and is a capital intensive firm. Small changes in sales volume would result in a large change in earnings and return on investment. One high risk scenario with this is when the high fixed costs continue to rise, but market demand for the product decreases. An example of a capital intensive business is an automobile manufacturing company.

If the ratio of fixed costs to revenue is high (i.e. >50%)  the company has significant operating leverage.  If the ratio of fixed costs to revenue is low (i.e. <20%) the company has little operating leverage.

Financial leverage – refers to the amount of obligation or debt a company has been or will be using to finance its business operations. Using borrowed funds, instead of equity funds, can really improve the company’s return on equity and earnings per share, given that the increase in earnings is greater than the interest paid on the loans. Excessive use of financing can lead to default and bankruptcy.  See the most common financial leverage ratios outlined below.

Combined leverage – applies to the combination of using operating leverage and financial leverage. For example, when viewing the balance sheet and income statement, operating leverage influences the upper half of the income statement through operating income while the lower half consists of financial leverage, wherein earnings per share to the stockholders can be assessed.

What are the Risks Involved in Having High Operating Leverage and High Financial Leverage?

If leverage can multiply earnings, it can also multiply risk. Having both high operating and financial leverage ratios can be very risky for a business.  A high operating leverage ratio illustrates that a company is generating few sales, yet has high costs or margins that need to be paid off. This may either result in a lower income target or insufficient operating income to cover other expenses and will result in negative earnings for the company. On the other hand, high financial leverage ratios occur when the return on investment (ROI) does not exceed the interest paid on loans. This will significantly decrease the company’s profitability and earnings per share.

What are the main leverage ratios?

The most common leverage ratios are:

Debt / Equity

Debt / Total Capital (Debt + Equity)

Debt /  EBITDA