Leverage Ratio

AAA

DEFINITION of 'Leverage Ratio'

Companies rely on a mixture of owners' equity and debt to finance their operations. A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet financial obligations.

INVESTOPEDIA EXPLAINS 'Leverage Ratio'

Too much debt can be dangerous for a company and its investors. Uncontrolled debt levels can lead to credit downgrades or worse. On the other hand, too few debts can also raise questions. If a company's operations can generate a higher rate of return than the interest rate on its loans, then the debt is helping to fuel growth in profits. A reluctance or inability to borrow may be a sign that operating margins are simply too tight.

There are several different specific ratios that may be categorized as a leverage ratio, but the main factors considered are include debt, equity, assets and interest expenses.

A leverage ratio may also refer to one used to measure a company's mix of operating costs, giving an idea of how changes in output will affect operating income. Fixed and variable costs are the two types of operating costs; depending on the company and the industry, the mix will differ. 

Finally, the consumer leverage ratio refers to the level of consumer debt as compared to disposable income and is used in economic analysis and by policymakers

Leverage Ratios for Evaluating Solvency and Capital Structure

The most well known financial leverage ratio is the debt-to-equity ratio. It is expressed as:

Total debt / Total Equity        

For example, if a company has $10M in debt and $20M in equity, it has a debt-to-equity ratio of 0.50 = ($10M/$20M). A high debt/equity ratio generally indicates that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense, and if it is very high, it may increase the chances of a default or bankruptcy. Typically a debt to equity ratio greater than 2.0 indicates a risky scenario for the investor, however this yardstick can vary by industry. Businesses that require large capital expenditures (CapEx) may need to secure more loans than other companies. It's a good idea to measure a firm's leverage ratios against past performance and its competitors' performance to better understand the data.

The financial leverage ratio is similar, but replaces debt with assets in the numerator: 

Avg. Total Assets/ Avg. Total Equity  

The financial leverage ratio is sometimes referred to as the equity multiplier. For example, a company has assets valued at $2 billion and stockholder equity of $1 billion. The equity multiplier value would be 2.0 ($2 billion / $1 billion), meaning that one half of a company’s assets are financed by equity. The balance must be financed by debt.

The financial leverage ratio is a component of the decomposed DuPont analysis for calculating return on equity (ROE):  

                                      ROE = Net Profit Margin x Asset Turnover x Financial Leverage Ratio                            

An indicator that measures the total amount of debt in a company’s capital structure is the debt-to-capitalization ratio, which measures a company’s financial leverage. It is calculated as:

Long-term Debt to Capitalization Ratio = Long-term Debt / (Long-Term Debt + minority interest + equity)

In this ratio, operating leases are capitalized and equity includes both common and preferred shares.

Total Debt to Capitalization Ratio = (current liabilities + Long-Term Debt) / (current liabilities + Long-Term Debt + minority interest + equity)

Degree of Financial Leverage 

Degree of financial leverage (DFL) is a ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. It measures the percentage change in EPS for a unit change in earnings before interest and taxes (EBIT), and is represented as:


DFL can also be represented by the equation below:

This ratio indicates that the higher the degree of financial leverage, the more volatile earnings will be. Since interest is usually a fixed expense, leverage magnifies returns and EPS. This is good when operating income is rising, but it can be a problem when operating income is under pressure.

Consumer Leverage Ratio

The consumer leverage ratio is used to quantify the amount of debt the average American consumer has, relative to their disposable income.

Some economists have stated that the rapid increase in consumer debt levels has been a main factor for corporate earnings growth over the past few decades. Others have blamed the high level of consumer debt as a major cause of the great recession.

Consumer Leverage Ratio = Total household debt/ Disposable personal income 

VIDEO

Loading the player...
RELATED TERMS
  1. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  2. Overleveraged

    Occurs when a business is carrying too much debt, and is unable ...
  3. Tier 1 Leverage Ratio

    The relationship between a banking organization's core capital ...
  4. Debt/Equity Ratio

    A measure of a company's financial leverage calculated by dividing ...
  5. Operating Leverage

    A measurement of the degree to which a firm or project incurs ...
  6. Leverage

    1. The use of various financial instruments or borrowed capital, ...
RELATED FAQS
  1. What is the typical debt/equity ratio of companies in the chemicals sector?

    The debt-to-equity ratio is equal to the ratio of total assets to total shareholder equity. It is a leverage ratio that measures ... Read Full Answer >>
  2. Which financial statements are most important when performing ratio analysis?

    Financial ratio analysis is an important aspect of fundamental analysis for any party engaged in value investing. Financial ... Read Full Answer >>
  3. What are some of the advantages and disadvantages of DuPont Analysis?

    DuPont analysis is a potentially helpful tool for analysis that investors can use to make more informed choices regarding ... Read Full Answer >>
  4. What is the long-term outlook of the banking sector?

    The long-term outlook of the banking sector remains cyclical, but with less volatility than in the past. Given structural ... Read Full Answer >>
  5. How can I use the debt-to-capital ratio to evaluate a stock?

    The debt to capital ratio is a leverage ratio that can be used to evaluate a company's financial soundness and potential ... Read Full Answer >>
  6. What is the difference between share purchase rights and options?

    There is a big difference between share purchase rights and options. With share purchase rights, the holder may or may not ... Read Full Answer >>
Related Articles
  1. Investing Basics

    Will Corporate Debt Drag Your Stock Down?

    Borrowed funds can mean a leg up for companies or the boot for investors. Find out how to tell the difference.
  2. Fundamental Analysis

    Ratio Analysis Tutorial

    If you don't know how to evaluate a company's present performance and its possible future performance, you need to learn how to analyze ratios.
  3. Fundamental Analysis

    4 Leverage Ratios Used In Evaluating Energy Firms

    These four leverage ratios can help investors understand how oil and gas firms are managing their debt.
  4. Investing Basics

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  5. Mutual Funds & ETFs

    Reinvesting Capital Gains In Leveraged Portfolios

    Don't get forced into action. Learn how to plan properly to avoid making rash decisions.
  6. Investing

    Understanding The Leverage Ratio

    Learn more on how the leverage ratio is used to calculate a company's ability to meet financial obligations and how changes in output will affect operating income.
  7. Options & Futures

    Borrowing Smart In A Debt-Filled World

    Leveraging your money can have many perks, but it's not always the smartest financial plan.
  8. Brokers

    Private Equity's Returns Are Tempered By Its Risks

    Private equity firms adopt approaches to quickly hike up earnings and boost returns, but these investments come with big risks too.
  9. Credit & Loans

    The Pros & Cons Of Personal Loans vs. Credit Cards

    One is not like the other. We help you decide where to borrow money from.
  10. Fundamental Analysis

    What is Gearing?

    Gearing, also called leverage, is the degree to which a company’s operations are funded by lenders versus shareholders.

You May Also Like

Hot Definitions
  1. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
  2. Moving Average - MA

    A widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Productivity

    An economic measure of output per unit of input. Inputs include labor and capital, while output is typically measured in ...
  5. Variance

    The spread between numbers in a data set, measuring Variance is calculated by taking the differences between each number ...
  6. Terminal Value - TV

    The value of a bond at maturity, or of an asset at a specified, future valuation date, taking into account factors such as ...
Trading Center