Leverage Ratios

What are Leverage Ratios?

Leverage ratios are financial ratios used to measure a company’s capital structure, financial obligations and its ability to clear those obligations. The financial aptitude of the company is measured by the investors, board of directors, creditors and others by using these ratios.

Every business at a certain point in time needs finance from investors and financial institutions to expand, but these loans and debts have to be controlled in order to generate earnings. The return earned on capital has to be greater than the interest rate paid on these loans and debt. If ROI > Interest, shareholder’s wealth is increased otherwise it depletes.

Leverage ratios comprise of ratios which measure the amount of debt and ability of the business entity to fulfill its financial obligations. Since business needs financing in the form of equity and debt, the ratios are also used to balance the two for a perfect mix of capital structure to balance out costs of capital.

Types of Leverage Ratios?

A leverage ratio is a financial ratio which can be defined as a financial metric to measure the capability of the company to pay off its dues or how much asset is put to use with the loan taken along with being a good indicator of capital structure. There are different ratios which are categorized as leverage ratios and they are as follows:

Debt-to-EBITDA

This is the ratio which is used to measure the capacity of the company to pay off its debt. It is mainly used by the credit rating agencies and financial institutions to check whether the company will be able to clear its debt or not and how efficiently they can do it.

Debt-to-Capital

It is used to compare the debt and the capital of a company. This is the ratio which is used to analyze the financial structure of the company and it also checks how the business operations are getting financed.

Debt-to-Equity

It is the comparison between the shareholder’s investment that is equity and the total liabilities (most of the time only long-term debts are taken into consideration). It is used to measure the proportion of company’s debt and equity.  Banking industry uses this ratio very frequently in their credit appraisal of businesses applying for a loan. It compares the investment made by the owners vs. the investment by the bank. Banks normally keep a provision of margin money to maintain this ratio and check the seriousness of the owners towards the business. For a detailed understanding, visit Debt to Equity Ratio.

Debt-to-Asset

This is the ratio which is a relation between the total debt of the company to its assets and this is used to understand how much debt is used to finance the assets of the company. Visit Debt to Total Asset Ratio.

Leverage Ratios

Calculation and Formula

The different leverage ratios and their formula are as follow –

Debt-to-EBITDA = Total Debt / EBITDA (Earnings Before Interest Taxes Depreciation & Amortization)

Debt-to-Capital = Total Debt / (Total Debt + Total Equity)

Debt-to-Equity = Total Debt / Total Equity

Debt-to-Asset = Total Asset / Total Assets

Examples

Let us assume ABC & Co. has INR 1000000 as capital comprised of 40% debt and 60% equity. The company’s earnings before interest and taxes (EBIT) are INR 100000. It has accounted for depreciation and amortization in its financial statements in the current financial year for INR 15000. The assets of the company amount to INR 750000.

Therefore, if we calculate the different leverage ratios then we will get –

Debt-to-EBITDA = Total Debt / EBITDA ( Earnings Before Interest Taxes Depreciation & Amortization) = 400000/(100000+15000) = 3.48

Debt-to-Capital = Total Debt / (Total Debt + Total Equity)

= 400000/ 1000000 = 0.4

Debt-to-Equity = Total Debt / Total Equity

= 400000/600000 = 0.67

Debt-to-Asset = Total Debt / Total Assets

= 400000/750000 = 0.53

Uses of Leverage Ratios

Leverage ratios analysis is important to both internal and external parties involved in a business whether it is the management, the creditors or the investors. Even the third parties like the credit rating agencies require these to get the operational efficiency of the company. These ratios are important as they give an insight into the company’s financial health, its capability to meet its financial liabilities and obligations. It is used to measure the potential and the efficiency of the company with which it is using the debt to run the business and earn revenue and expand as well. Leverage ratios use can be many as it is also used to understand the capital structure of the company and whether it is solvent or not. The creditor can rely on these ratios to extend credit to the company even if the company is highly levered but earning good returns on their investment surpassing the interest cost of capital.

Conclusion

Leverage ratios are used to measure solvency of a company, its financial structure and how it operates with the given fund (equity and debt). It is used by creditors, investors as well as the internal management to evaluate the company’s growth, ability to clear all dues/debts/interests.

References:

https://www.investopedia.com/terms/l/leverageratio.asp

https://corporatefinanceinstitute.com/resources/knowledge/finance/leverage-ratios/

http://www.investinganswers.com/dictionary/leverage-ratio

https://www.investopedia.com/articles/fundamental-analysis/12/4-leverage-ratios-used-in-evaluating_energy_firms.asp

https://www.investopedia.com/terms/t/totaldebttototalassets.asp

Last updated on : August 31st, 2018

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