A Deep Dive into Leverage Ratios

Key Takeaways

• Leverage is the result of employing borrowed capital as a funding source when investing to grow a company’s asset base and produce returns on risk capital.
• Leverage ratios show the amount of debt a business entity incurs against other accounts on its cash flow or income statement, or balance sheet.
• Leverage ratios are important in that they offer a clear and simple way to see how reliant a company is on debt to fund its operations and grow.

Leverage ratios are key financial metrics for investors as well as lenders and business owners because they gauge the amount of debt a company leverages for operations. To help investors understand the ins and outs of such measurements, here is a deep dive into leverage ratios.

What is a Leverage Ratio?

There are several types of leverage ratios, all of which show the amount of debt a business entity incurs against other accounts on its cash flow or income statement, or balance sheet. Such ratios indicate how the company’s operations and assets are financed, whether using equity or debt.

Using leverage can help a company when it is earning profits, as such profits become magnified. By contrast, a company that is highly levered will likely have difficulties if profits fall and could be at elevated default risk.

What are the Different Leverage ratios?

There are a number of different leverage ratios that may be employed, including:

Debt-to-Equity

This may be the most well-known financial leverage ratio, an equation expressed as Debt-to-Equity Ratio = Total Debt / Total Equity.

For example, the long-term debt for United Parcel Service for the quarter ending June 30 was \$19.35 billion and its overall stockholders’ equity was \$20 billion. For the quarter, the company’s D/E was 0.97. While it varies by industry, a D/E ratio exceeding 2.0 could mean investor risk.

Equity Multiplier

This ratio is similar but supplants debt with assets in the equation: Equity Multiplier = Total Assets / Total Equity.

In an example, Macy’s assets are valued at \$19.85 billion with stockholder equity totaling \$4.32 billion. Thus, the equity multiplier would look like this: \$19.85 billion divided by \$4.32 billion = 4.5.

Although debt is not specifically part of the formula per se, because total assets includes debt, debt is an underlying factor.

DuPont Analysis

The equity multiplier is part of the DuPont analysis for determining return on equity. The calculation is DuPont analysis = NPM x AT where:

NPM = net profit margin

AT = asset turnover

EM = equity multiplier

A low equity multiplier is generally better since it means a company is not taking on a lot of debt to finance its assets.

Debt-to-Capitalization

This ratio gauges total debt in a company’s capital structure and is calculated thusly: Total debt to capitalization = (SD + LD) / (SD + LD + SE).

Here, equity includes preferred and common shares and operating leases are capitalized. An analyst may employ total debt rather than long-term debt to assess the debt used in a company’s capital structure. In this case, the formula would include in the denominator preferred shares and minority interest.

Degree of Financial Leverage

This is a ratio that gauges a company’s earnings-per-share (EPS) to operating income fluctuations, due to capital structure changes. It measures the percentage change in earnings per share before interest rate and taxes. It is expressed as:

DFL = % change in EPS / % change in EBIT

Where:

EPS = earnings per share

EBIT = earnings before interest

This ratio shows that the more the financial leverage, the more volatile the earnings. Because interest is typically a fixed expense, leverage magnifies EPS and returns. While this can be a positive when operating income is increasing, it can be problematic when such income is under stress.

Consumer Leverage Ratio

This ratio is employed to determine how much debt the average U.S. resident carries relative to their disposable income. The calculation is Consumer Leverage Ratio = Total household debt / Disposable personal income.

Note that, according to some economists, the swift rise in consumer debt levels has contributed over the last few decades to corporate earnings growth.

Debt-to-Capital Ratio

This ratio focuses on how debt liabilities, including short- and long-term, relate as part of a company’s total capital base, and is calculated as Debt / (Total Debt + Total Equity).

The ratio is employed to gauge a company’s financial structure and how operations are financed. Generally, the level of default risk is commensurate with a company’s debt-to-capital ratio. An excessively high ratio means earnings may be insufficient to cover the cost of liabilities and debts.

Debt-to-EBITDA Leverage

This ratio gauges how much income is generated and accessible to slash debt before accounting for taxes, interest, depreciation, and amortization costs. The ratio is calculated by dividing the long- and short-term debt by EBITDA, which determines the likelihood of issued-debt default.

This ratio is commonly used to determine the number of years EBITDA would need to repay all obligations and should be under the figure 3.

Debt to EBITDAX Ratio

The difference between this ratio and the debt-to-EBITDA leverage is that the former measures against EBITDAX (earnings before interest, taxes, depreciation, amortization, and exploration expense) instead of EBITDA. Here, EBITA is expanded by excluding exploration expenses.

The ratio is often used in the U.S. to normalize varying accounting treatments for exploration expenses.

Interest Coverage Ratio

This ratio demonstrates the company’s ability to render interest payments, with a calculation of operating income divided by interest expenses. In general, a desirable ratio is 3.0 or higher, depending on the industry.

Fixed Charge Ratio

This ratio seeks to quantify cash flow relative to the amount of interest owed on long-term debts. Calculation requires finding the company’s earnings before interest and taxes, then dividing the interest expense of long-term obligations. Pret-tax earnings are used since interest is tax deductible, and total earnings can ultimately be used to pay interest. Higher numbers are preferable.

How is Leverage Created?

Leverage is the result of employing borrowed capital as a funding source when investing to grow a company’s asset base and produce returns on risk capital.

What is a Good Leverage Ratio?

By industry standards, a leverage ratio of under 1 is typically considered favorable, with a figure of less than .5 ideal. Another way to say it is, not more than 50% of the company’s assets should be financed by debt.

Note, though, that many investors abide markedly higher ratios.

Why are Leverage Ratios Important?

Leverage ratios are important in that they offer a clear and simple way for investors and other stakeholders to see how reliant a company is on debt to fund its operations and grow.

Essentially, their importance derives from companies’ reliance upon a combination of debt and equity for operations, and learning the amount of debt a company holds can help when evaluating whether it can clear its obligations when due.

Uncontrolled debt levels can result in credit downgrades. On the other hand, an inability or disinclination to borrow may mean tight operating margins.

How Do Leverage Ratios Impact Venture Capital Funds?

Venture capital (VC), which is a form of private equity, is a type of investor financing for small businesses and startups. Investors in VC funds should understand the above ratios to gain insight on fund and investor performance, as well as internal budgeting.

How to Invest in VC?

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In Summary

Leverage ratios are important in that they show investors, companies, and lenders how a business is using its borrowed funds. They also assess capital structure and company solvency. Keep in mind that such ratios affect VC funds, investments which can help with portfolio diversification.

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