What is a '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.
BREAKING DOWN '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.
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.
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.
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