What is a Leverage Ratio
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 its financial obligations. The leverage ratio is important given that companies rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due.
Understanding The Leverage Ratio
BREAKING DOWN Leverage Ratio
Too much debt can be dangerous for a company and its investors. However, 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. Nonetheless, uncontrolled debt levels can lead to credit downgrades or worse. On the other hand, too few debt can also raise questions. 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 debt, equity, assets, and interest expenses.
A leverage ratio may also be used to measure a company's mix of operating expenses to get 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:
D/E Ratio = Total Debt / Total Equity
For example, Macy's has $15.53 billion in debt and $4.32 billion in equity, as of fiscal year ended 2017. The company's debt-to-equity ratio is $15.53 billion / $4.32 billion = 3.59. Macy's liabilities are 359% of shareholders' equity which is very high for a retail company.
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. If the company's interest expense grows too high, it may increase the company's chances of a default or bankruptcy. Typically, a D/E ratio greater than 2.0 indicates a risky scenario for an investor, however this yardstick can vary by industry. Businesses that require large capital expenditures (CapEx), such as utility and manufacturing companies, 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 with companies operating in the same industry to better understand the data.
The equity multiplier is similar, but replaces debt with assets in the numerator:
Equity Multiplier = Total Assets / Total Equity
For example, assume that Macy's (NYSE: M)has assets valued at $19.85 billion and stockholder equity of $4.32 billion. The equity multiplier would be $19.85 billion / $4.32 billion = 4.59. Although debt is not specifically referenced in the formula, it is an underlying factor given that total assets includes debt. Remember that total Assets = Total Debt + Total shareholders' Equity. The company's high ratio of 4.59 means that assets are mostly funded with debt than equity. From the equity multiplier calculation, Macy's assets are financed with $15.53 billion in liabilities.
ROE = Net Profit Margin x Asset Turnover x Equity Multiplier
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. Instead of using long-term debt, an analyst may decide to use total debt to measure the debt used in a firm's capital structure. The formula, in this case, is:
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
Understanding how debt amplifies returns is the key to understanding leverage, but as you can see if comes in several forms of analysis. Debt by itself is not necessarily a bad thing, especially if debt is taken on to make larger investments into projects that will generate positive returns. Leverage can thus multiply returns - but also magnify losses if returns turn out to be negative.