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For banks and businesses alike, leverage ratios are useful indicators of how their assets are financed, whether through debt or equity. It's also a useful metric for market analysts and investors to consider since it's an assessment of how easily a company will be able to meet financial obligations. But what is leverage ratio? Find out everything you need to know.
Understanding leverage ratio
Leverage ratio refers to the proportion of debt compared to equity or capital. It's often used by banking institutions to track finances. However, businesses also make use of this ratio. A company's financial leverage ratio shows the level of debt in comparison to its accounts, such as the income statement, cash flow statement, or balance sheet.
What is leverage, and how is it created?
Companies rely on a blend of equity and debt to finance their operations. Leverage is created through many different scenarios, with the end goal of obtaining this financing. Here are a few examples:
Asset-backed lending: Taking on debt to purchase fixed assets like property, machinery, and equipment.
Cash flow loans: Taking on debt based on the business's creditworthiness. This type of loan is usually only available to larger companies, not start-ups.
Leveraged buyouts: Private equity firms might take on debt to buy out the company.
Financial instruments: An individual might purchase options, margins, or similar instruments.
Equity investing: Investors can borrow money to use as leverage in their portfolios.
What does the leverage ratio represent?
Any investor knows that too much debt is a risky proposition. If a company can generate higher return rates than the interest rates and repayments on its loans, the debt might be a useful tool for growth. Leverage ratio assesses this level of risk by showing you the proportion of debt to assets or cash.
There are also operational leverage ratios, which are separate from finance leverage ratios. This type of formula shows how changes in operational output or expenses will impact income. The third type of leverage ratio relates to consumer debt, which is compared to disposable income. This is used to assess creditworthiness or in a more exhaustive fiscal analysis.
Types of leverage ratio
We've just gone over several types of leverage ratios, primarily financial, operational, and consumer. Although most of them factor debt into the equation, the other component of the ratio could be equity, capital, or assets. Therefore, the leverage ratio formula could be written in several ways, depending on what's being compared to your outstanding debt or assets:
How do you calculate a financial leverage ratio?
To calculate this type of ratio, you can use one of the leverage ratio formulas mentioned above. For example, imagine a business with the following finances:
$30 million in assets
$15 million in debt
$20 million in equity
Here's how to calculate the financial leverage ratios:
Debt / Equity = $15 / $20 = 0.75
Debt / Assets = $15 / $30 = 0.5
Debt / Capital = $15 / ($15 + $20) = 0.43
Why is this useful? Let's take the debt to equity ratio above. This shows that this business's ratio is 0.75, which indicates that equity makes up most of its resources.
What risks are involved with high leverage?
Although high leverage can potentially lead to greater rewards, it can also cause greater uncertainty or risk. A high financial leverage ratio indicates that the return on investment isn't high enough to offset the interest paid on debt. This decreases overall profitability. High operating leverage ratios are also problematic, as they indicate the company isn't generating enough sales in comparison to its high costs of operation. All these figures must be examined together to gain a better picture of the business's current financial health.
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