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 category is important because 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. Several common leverage ratios will be discussed below.
Understanding The Leverage Ratio
What Does a Leverage Ratio Tell You?
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 debts 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.
Banks and Leverage Ratios
Banks are among the most leveraged institutions in the United States. The combination of fractional-reserve banking and Federal Deposit Insurance Corporation (FDIC), protection has produced a banking environment with limited lending risks.
To compensate for this, three separate regulatory bodies, the FDIC, the Federal Reserve and the Comptroller of the Currency, review and restrict the leverage ratios for American banks. This means they restrict how much money a bank can lend relative to how much capital the bank devotes to its own assets. The level of capital is important because banks can "write down" the capital portion of their assets if total asset values drop. Assets financed by debt cannot be written down because the bank's bondholders and depositors are owed those funds.
Banking regulations for leverage ratios are very complicated. The Federal Reserve created guidelines for bank holding companies, although these restrictions vary depending on the rating assigned to the bank. In general, banks that experience rapid growth or face operational or financial difficulties are required to maintain higher leverage ratios.
There are several forms of capital requirements and minimum reserve radios placed on American banks through the FDIC and the Comptroller of the Currency that indirectly impacts leverage ratios. The level of scrutiny paid to leverage ratios has increased since the Great Recession of 2007-2009, with the concern about large banks being "too big to fail" serving as a calling card to make banks more solvent. These restrictions naturally limit the number of loans made because it is more difficult and more expensive for a bank to raise capital than it is to borrow funds. Higher capital requirements can reduce dividends or dilute share value if more shares are issued.
For banks, the tier 1 leverage ratio is most commonly used by regulators.
- 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.
- 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.
- Common leverage ratios include the debt-equity ratio, equity multiplier, degree of financial leverage, and consumer leverage ratio.
- Banks have regulatory oversight on the level of leverage they are able to have, as measured by leverage ratios.
Leverage Ratios for Evaluating Solvency and Capital Structure
The Debt-to-Equity (D/E) Ratio
Perhaps the most well known financial leverage ratio is the debt-to-equity ratio. It is expressed as:
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 thus $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
The equity multiplier is similar, but replaces debt with assets in the numerator:
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.
The equity multiplier is a component of the DuPont analysis for calculating return on equity (ROE):
The Debt-to-Capitalization Ratio
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:
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, would include minority interest and preferred shares in the denominator.
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 alternatively 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.
The 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.
Understanding how debt amplifies returns is the key to understanding leverage, but as you can see, it comes in several forms of analysis. Debt by itself is not necessarily a bad thing, especially if the debt is taken on to make larger investments into projects that will generate positive returns. Leverage can thus multiply returns, though it can also magnify losses if returns turn out to be negative.
The Debt-to-Capital Ratio
The debt-to-capital ratio is a measurement of a company's financial leverage. It is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a company's total capital base. Debt includes all short-term and long-term obligations. Capital includes the company's debt and shareholder's equity.
This ratio is used to evaluate a firm's financial structure and how it's financing operations. Typically, if a company has a high debt-to-capital ratio compared to its peers, then it may have a higher default risk due to the effect the debt has on its operations. The oil industry seems to have about a 40% debt-to-capital threshold. Above that level, debt costs increase considerably.
The Debt-to-EBITDA Leverage Ratio
The debt-to-EBITDA leverage ratio measures a company's ability to pay off its incurred debt. Commonly used by credit agencies, it determines the probability of defaulting on issued debt. Since oil and gas companies typically have a lot of debt on their balance sheets, this ratio is useful in determining how many years of EBITDA would be necessary in order to pay back all the debt. Typically, it can be alarming if the ratio is over 3, but this can vary depending on the industry.
The Debt-to-EBITDAX Ratio
Another variation of the debt-to-EBITDA ratio is the debt-to-EBITDAX ratio, which is similar, except EBITDAX is EBITDA before exploration costs for successful efforts companies. This ratio is commonly used in the United States to normalize different accounting treatments for exploration expenses (the full cost method versus the successful efforts method).
Exploration costs are typically found in the financial statements as exploration, abandonment, and dry hole costs. Other noncash expenses that should be added back in are impairments, accretion of asset retirement obligations and deferred taxes.
The Interest Coverage Ratio
Another leverage ratio concerned with interest payments is the interest coverage ratio. One problem with only reviewing the total debt liabilities for a company is they do not tell you anything about the company's ability to service the debt. This is exactly what the interest coverage ratio aims to fix.
This ratio, which equals operating income divided by interest expenses, showcases the company's ability to make interest payments. You generally want to see a ratio of 3.0 or higher, although this varies from industry to industry.
The Fixed-Charge Coverage Ratio
Times interest earned (TIE), also known as a fixed-charge coverage ratio, is a variation of the interest coverage ratio. This leverage ratio attempts to highlight cash flow relative to interest owed on long-term liabilities.
To calculate this ratio, find the company's earnings before interest and taxes (EBIT), then divide by the interest expense of long-term debts. Use pre-tax earnings because interest is tax-deductible; the full amount of earnings can eventually be used to pay interest. Again, higher numbers are more favorable.