Leverage Ratios

A class of ratios that measure the indebtedness of a firm

What are leverage ratios?

A leverage ratio is any kind of financial ratio that indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. It provides an indication of how much assets are coming from loans to finance business operations.  Below is an illustration of two leverage ratios: debt/equity and debt/capital.

leverage ratio example

 

Common leverage ratios

There are several difference leverage ratios. Some accounts that are considered to have significant comparability to debt are total assets, total equity, operating expenses and incomes, and interest expense.

Below are just two of these accounts and the ratios that use them:

  • Debt-to-Assets Ratio = Total Debt / Total Assets
  • Debt-to-Equity Ratio = Total Debt / Total Equity
  • Debt-to-Capital Ratio = Today Debt / (Total Debt + Total Equity)
  • Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization

 

Leverage ratio example

If a business has total assets worth $100 million, with total liabilities of $45 million, and total equity of $55 million, then the proportionate amount of borrowed money against total assets is .045 or less than half of its total resources. When comparing debt to equity, the ratio for this firm is 0.82 meaning equity still makes up a majority of the firm’s assets. This firm is, thus, quite leveraged.

 

Importance and usage

Leverage ratios represent the extent to which a business is utilizing borrowed money. It also evaluates company solvency and capital structure. Having high leverage in a firms capital structure can be risky, but is also quite beneficial during times when the firm is earning. On the other hand, however, a highly levered firm will have trouble when it is on the decline and may be at a higher risk of bankruptcy than an unlevered firm in the same situation. Finally, analyzing the existing level of debt is an important factor that creditors analyze when a firm wishes to apply for further borrowing.

 

What are the various types of leverage?

1 Operating leverage

An operating leverage ratio refers 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.

2 Financial leverage

A financial leverage ratio 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.

3 Combined leverage

A combined leverage ratio refers 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.

 

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 use 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.

 

What are the risks of 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.

 

Additional resources

This leverage ratio guide has introduced the main ratios, Debt/Equity, Debt/Capital, and Debt/EBITDA.  Below are additional relevant resources to help you advance your career.