What is a leverage ratio
A leverage ratio is a corporate finance term that refers to one of many different ratios that measure the level of debt, or the amount of financial leverage, that a company uses to fund its operations. . Investors use debt ratios to better understand a company’s debt burden.
Understanding Leverage Ratios
In finance, leverage is a term that refers to the use of debt to raise capital in the hope that this capital can generate a gain that will exceed the cost of debt. As in the physical scientific application of the term, leverage can allow its user to carry or move a heavier load than they could without the use of leverage.
For example, many leverage ratios measure a company’s debt relative to its assets. Leverage ratios generally tell company management, shareholders, and other stakeholders how risky the company is within its capital structure.
Important: Using debt to raise capital and finance a company’s projects or operations is not without risk. For this reason, business analysts and investors use leverage ratios to determine whether a company’s leverage potentially helps or hinders its growth. Too much debt can be too risky, while too little debt can hamper growth or even indicate an inability to find lenders, perhaps due to low profitability.
Leverage ratios in the banking sector
The banking sector is one of the most indebted sectors in the United States. For this reason, and because they are an essential component of the American economy, banks are also among the most regulated companies. For regulatory purposes, the federal government will periodically review banks’ leverage ratios.
The regulatory bodies that monitor banks’ leverage ratios are the Federal Reserve, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (FDIC). Capital requirements and reserve requirements, especially since the Great Recession of 2007 to 2009, have increased scrutiny of bank leverage ratios.
The most commonly used leverage ratio for banks is the Tier 1 leverage ratio, which compares a bank’s Tier 1 capital to its total assets. Tier 1 capital is a measure of a bank’s assets that can be easily liquidated in the event of a financial crisis.
Leverage Ratio Types, Formulas, and Examples
There are several types of leverage ratios used to measure how much of a company’s capital is in the form of debt. A company’s management, investors, and other stakeholders can use these ratios to assess a company’s ability to meet its financial obligations.
Here are the 9 main types of leverage ratios:
- Equity multiplier
- Debt ratio (D/E)
- Interest coverage ratio
- Fixed charge coverage rate
- Debt/EBIDTA ratio
- Degree of financial leverage
- Consumer debt ratio
- Rate of endettement
- Debt to capitalization ratio
Equity Multiplier Formula and Example
The equity multiplier is a risk indicator used to measure the proportion of a company’s operations financed by equity rather than debt. Investors generally prefer a lower equity multiplier because it indicates that a company is using more equity and less debt to finance itself. However, it is important to note that the use of debt can improve earnings leverage, so companies with low equity multipliers may forego these earnings leverage opportunities. due to the choice or inability to obtain debt financing.
Here is the formula for the equity multiplier:
Equity Multiplier = Total Assets / Total Equity
For example, if a company’s total assets on the balance sheet were $50 billion and the book value of its equity was $10 billion, the equity multiplier would be 5, or $50 billion. divided by $10 billion. To determine whether or not this was a good equity multiplier, an investor could compare this multiplier to the company’s previous year’s multiplier or that of its competitors.
Debt Ratio Formula and Example
The debt-to-equity ratio (D/E) is used to measure a company’s level of debt by comparing its total liabilities to its equity. A high D/E ratio indicates that a company has a high level of liabilities, probably including debt, relative to equity. A high D/E ratio is potentially a negative indicator. However, debt financing can boost earnings leverage, so a low debt ratio is not necessarily good and a higher debt ratio is not necessarily bad.
Here is the formula for the D/E ratio:
D/E = Total Liabilities / Total Equity
For example, if you look at a company’s balance sheet and see that its total liabilities for a given period were $50 million and its equity was $100 million, the company’s D/E ratio would be of 0.5, or $50 million / $100 million.
Interest coverage ratio formula and example
Sometimes called the Times Interest Earned (TIE) ratio, the interest coverage ratio is a measure of risk used to determine how easily a company can pay the interest on its debt. Generally, a higher interest coverage ratio is preferable, although the ideal ratio may vary from industry to industry.
Here is the formula for the interest coverage ratio (note that EBIT is earnings before interest and taxes):
Interest coverage = EBIT / Interest expense
For example, if a company’s EBIT in a given quarter is $30 million and its debt payments per month are $2 million (or $6 million per quarter), the calculation of interest coverage would be 5x, or $30 million / $6 million.
Fixed Charge Coverage Ratio Formula and Example
The fixed charge coverage ratio (FCCR) is used to measure how well a company’s profits can cover its fixed expenses, such as interest charges, lease payments, and debt repayments. This ratio is commonly used by lenders to assess a company’s creditworthiness.
Here is the formula for the fixed charge coverage ratio:
FCCR = (EBIT + FCBT) / FCBT + interest expense
EBIT = Earnings Before Interest and Taxes
FCBT = Fixed Charges Excluding Taxes
For example, if a business has EBIT of $600,000, lease payments of $400,000, and $100,000 in interest expense, the calculation would be $600,000 plus $400,000 divided by $400,000 plus 100 $000. Broken down further, that would be $1 million divided by $500,000, which equals an FCCR of 2x.
Some investors might be curious to know why the FCBT is added in the numerator of the FCCR calculation. Indeed, if the intention is to measure the coverage by a company of its fixed costs, the starting point would be before the subtraction of these costs.
Debt to EBITDA Ratio Formula and Example
The debt-to-EBITDA ratio, or debt-to-EBITDA, measures the income a company has to pay its expenses before interest, taxes, depreciation and amortization (EBITDA). A lower debt to EBITDA ratio generally indicates that a company has manageable debt.
Here is the debt/EBITDA formula:
Debt to EBITDA = Debt / EBITDA
For example, if a company’s total debt on its balance sheet is $200 million and it has $20 million in EBITDA, the debt to EBITDA ratio would be $10.200 million divided by $20 million. of dollars.
Leverage degree formula and example
The degree of financial leverage, or DFL, is a leverage ratio that shows how the degree of variation in earnings per share is related to fluctuations in its operating profit. A company can use DFL to determine if it can safely add more debt to finance a project. A higher DFL generally indicates that earnings will be more volatile.
Here is the formula for the degree of financial leverage:
DFL = % change in net income / % change in EBIT
Consumer Leverage Ratio Formula and Example
The consumer debt ratio is a measure of the total amount of debt of the average American household relative to personal disposable income. As is the case with debt ratios used at the corporate level, debt can be good for the economy, but too much debt can indicate economic weakness.
Here is the formula for the consumer leverage ratio:
Consumer Leverage = Total Household Debt / Personal Disposable Income
Total debt and personal income are reported by the Federal Reserve. The average consumer debt ratio is 0.9. An example of a high ratio was in 2007, when the consumer debt ratio was 1.29. A financial crisis and the Great Recession soon followed.
Debt-to-income ratio formula and example
The debt-to-income ratio (DTI) measures the amount of monthly debt payments a household or corporation pays as a percentage of gross monthly income. Lenders use DTI to determine a borrower’s creditworthiness.
Here’s how to calculate the debt-to-income ratio:
DTI = Monthly Debt Payments / Gross Monthly Income
For an example of a personal household, suppose a couple applies for a mortgage and the lender requires the household’s DTI, including future mortgage payment, to be less than 36% to approve the loan.
The couple have credit card debt and two car loans, totaling $1,000 in monthly payments. The new mortgage payment is estimated at $1,500 per month. The couple’s total gross family income is $7,500. Their DTI without the mortgage is 13.3%, or $1,000 divided by $7,500. Their DTI with the new mortgage is 33.3%, or $2,500 divided by $7,500.
Debt to capitalization ratio formula and example
The debt-to-capitalization ratio measures a company’s total debt as a percentage of its total capital. Businesses can use debt or equity to raise capital to fund their operations. Having too much debt relative to a company’s capitalization can indicate a higher risk of insolvency.
Here is the formula for the debt-to-capitalization ratio:
Capitalization Debt = Total Debt / (Total Debt + Equity)
Note: Total debt equals short-term debt plus long-term debt.
For example, suppose a company has short-term debt of $10 million, long-term debt of $40 million, and equity of $30 million. To calculate the company’s debt to capitalization ratio, you would divide the total debt of $50 million by the total capitalization of $80 million and you would get a ratio of 0.625. This indicates that 62.5% of the company’s capital is financed by debt.
Important: When analyzing leverage ratios, it can be helpful to compare these metrics to historical company metrics and industry peer ratios.