Loading the player...

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. 

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, Macy's 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.

The equity multiplier is a component of the DuPont analysis for calculating return on equity (ROE):  

ROE = Net Profit Margin x Asset Turnover x Equity Multiplier                           

An indicator that measures the 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. 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:

Degree of Financial Leverage with EPS in the numerator
DFL can also be represented by the equation below:

Degree of Financial Leverage with EBIT as numerator

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 

RELATED TERMS
  1. Capital Structure

    A mix of a company's long-term debt, specific short-term debt, ...
  2. Long-Term Debt To Capitalization ...

    A ratio showing the financial leverage of a firm, calculated ...
  3. Leverage

    The use of various financial instruments or borrowed capital, ...
  4. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
  5. Equity Multiplier

    The ratio of a company’s total assets to its stockholder’s equity. ...
  6. Debt Financing

    Debt financing occurs when a firm raises money for working capital ...
Related Articles
  1. Investing

    Debt Ratios

    Learn about the debt ratio, debt-equity ratio, capitalization ratio, interest coverage ratio and the cash flow to debt ratio.
  2. Investing

    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, ...
  3. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    These four leverage ratios can help investors evaluate how energy manage their debt.
  4. Investing

    Debt Ratio

    The debt ratio divides a company’s total debt by its total assets to tell us how highly leveraged a company is—in other words, how much of its assets are financed by debt. The debt component ...
  5. Investing

    Evaluating a Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  6. Investing

    Equity Multiplier

    The equity multiplier is a straightforward ratio used to measure a company’s financial leverage. The ratio is calculated by dividing total assets by total equity.
  7. Investing

    Why do Debt to Equity Ratios Vary From Industry to Industry?

    Obtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries.
  8. Investing

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  9. Investing

    Analyzing Verizon's Debt Ratios in 2016 (VZ)

    Analyze Verizon's key debt ratios, and understand how the company has been able to expand in recent years by safely increasing its debt load.
RELATED FAQS
  1. If a company has a high debt to capital ratio, what else should I look at before ...

    Learn about some of the financial leverage and profitability ratios that investors can analyze to supplement examining the ... Read Answer >>
  2. What are financial risk ratios and how are they used to measure risk?

    Explore some of the primary financial risk ratios that investors and analysts commonly use to evaluate a company's overall ... Read Answer >>
  3. What is the difference between the capital adequacy ratio and the leverage ratio?

    Explore what differentiates the capital adequacy ratio from any one of several leverage ratios used for equity evaluation ... Read Answer >>
  4. What is the difference between the gearing ratio and the debt-to-equity ratio?

    Dive deeper into gearing ratios: what are they, how are they used and why the debt to equity ratio is one of the most popular ... Read Answer >>
  5. How do I calculate the debt-to-equity ratio in Excel?

    Understand the basics of the debt to equity ratio, how it is interpreted as a measure of financial stability and how it is ... Read Answer >>
Hot Definitions
  1. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  2. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  3. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  4. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  5. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  6. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
Trading Center