Obtaining capital is a challenging task for any firm. When it comes to parting with their funds, every lender has its norms, hopes, and doubts.
In the middle of that journey, a firm must understand several indicators and impediments, one of which is called leverage ratio.
We will discuss the leverage ratio in this article, along with its meaning and how to compute it.
What is Leverage Ratio?
The Leverage ratio shows how much debt an organization has taken on to finance its assets and commercial operations.
A firm that uses debt to finance its assets and operations will have a higher financial leverage ratio. This occurrence is usually a red flag for potential investors that the company might not be a safe investment.
It could imply erratic earnings, a long wait before shareholders receive a significant return, or even the imminent insolvency of the company.
Creditors also use these measures to decide whether to grant credit to firms. A corporation with a high leverage ratio is more likely to default on loans because most of its cash flow is toward debt repayment.
A company with a stable income stream and a lower financial leverage ratio is typically more financially prudent. On the other hand, a lower financial leverage ratio signals to potential investors and lenders that a business poses little danger and is probably not worth investing in.Now after understanding the leverage ratio meaning, let’s move on to understanding the ideal leverage ratios.
What is the Ideal Leverage Ratio?
Different levels of leverage are ideal depending on the ratio you’re discussing. Higher numbers are preferable for some ratios, like the interest coverage ratio. However, smaller ratios typically represent organizations that are functioning well.
For instance, you want your debt-to-equity ratio, perhaps the most important financial leverage ratio, to be lower than 1. A ratio of 0.1 signifies that a company’s debt to equity is almost zero, and a ratio of 1 shows that a business’s debt and equity are equivalent. A highly good ratio will generally fall between 0.1 and 0.5.
Types Of the Leverage Ratio
There are three different types of leverage ratios. Each ratio belongs to one of the groups below. And each group serves a purpose and demonstrates different financial information about a business.
Operating Leverage
While examining operating leverage, you analyze a business’s variable and fixed costs. An organization with a high operating leverage ratio likely has a high fixed expense level. This typically denotes a capital-intensive business.
High demand for a particular item might have a favorable effect on a capital-intensive business. Sales increase, as a result, of increasing earnings. The price the business may charge rises with demand, improving return on investment.
If the reverse situation were to occur, it might be disastrous. Lower earnings might not meet the fixed costs if the demand for the item declines.
Financial Leverage
The amount of borrowing a company uses to finance its operations is compared to financial leverage ratios. A corporation can experience several benefits when it uses borrowed capital rather than equity stock.
This only occurs if the company’s profit growth outpaces the loan cost as interest. A company may go bankrupt if it depends too heavily on external financing.
Combined Leverage
As its name suggests, these ratios are created by combining operating and financial leverage. Looking at a company’s financial statements often reveals combined leverage.
Operating leverage is disclosed in the income statement, and financial leverage is disclosed on the balance sheet. It is possible to evaluate combined leverage by looking at them together.
How do Businesses Create Leverage?
There are several ways for a business to create leverage. The company’s sector determines how to create leverage in all of these situations.
The following are some ways a business can use to generate leverage:
- When a company directly purchases assets without raising debt, it increases its capital without increasing debt, which increases leverage.
- When a company purchases assets using debt, it increases its leverage.
- When a credit is taken by the businesses on its reputation to pay the credit on time.
- A company that borrows money to acquire another business increases its leverage.
Common Leverage Ratios
Financial experts, traders, or creditors may take into account a variety of different leverage ratios. Here are some of the most popular leverage ratios:
Debt to Equity Ratio
A high debt-to-equity ratio often indicates that a company has used debt to fund the majority of its expansion. As a result, earnings may fluctuate depending on the industry. This is brought on by the increased interest costs incurred each month. If this isn’t controlled, it may cause a corporation to default.
A debt-to-equity ratio of 2 or above is seen as dangerous. Nevertheless, this number fluctuates between industries and the nature of business. It’s anticipated that some companies would borrow more money to operate. For instance, Capital intensive corporations like infrastructure companies borrow huge sum of money for their operations as their returns grow in the long term.
Debt-to-Equity Ratio = Total Debt / Total Equity
Debt to EBITDA Ratio
EBITDA or Earnings Before Interest, Taxes, Depreciation, and Amortization, is a useful indicator for assessing a business’s financial success and capacity to provide cash flow for its shareholders.
This leverage ratio examines the ability of a business to pay off its debt. It is frequently employed by banking or credit organizations. These institutions utilize it because it predicts the probability of loan default.
Debt-to-EBITDA Ratio = Total Debt / EBITDA
This ratio is expressed by figuring out how many years it will take EBITDA to pay off any debt. The majority of sectors prefer to keep this ratio below 3. If so, it might start to seem a little concerning.
But there is another method to state this ratio. Costs associated with exploration may also be included. Companies do so to standardize various accounting methods for these expenses. This method may be employed, depending on the business.
Debt to Capital Ratio
Being one of the more useful leverage ratios, it concentrates on a company’s debt obligations and contrasts them with the entire capital base of the business. This percentage includes all short-term and long-term debts. Both debt and shareholder’s equity are considered to be capital.
Debt-to-Capital Ratio = Total Debt / (Total Equity + Total Debt)
It is one of the most popular methods of analyzing a company’s financial structure, as it examines the company’s financial strategy as well. It would be best to examine a company’s peers while examining the debt-to-capital ratio.
Companies with larger debt-to-capital ratios run more risks. This is due to the potential effect debt may have on their business. A lower ratio denotes more monetary stability.
Coverage ratios and their uses with Leverage ratios
Leverage ratios are helpful but can also be used with other ratios. You may get a more realistic image of a firm by combining them with coverage ratios. Measures of a company’s capacity to meet its financial obligations are called coverage ratios. Let’s look at a couple of them.
Interest Coverage Ratio
This ratio is focused on a company’s capacity to pay interest. Debt interest is one of the biggest problems when taking on debt. You are obligated to repay charges in addition to the principal loan amount.
A typical leverage ratio, however, says little about the company’s capacity to pay back debts. The interest coverage ratio helps to know about that.
It demonstrates the business’s capacity to repay debts and interest. The ratio should be at least 3, while the exact value varies by industry.
Interest Coverage Ratio = Operating Income / Interest Expense
Fixed Charge Coverage Ratio
The Fixed charge coverage ratio examines a business’s cash flow about the interest in its long-term commitments.
Pre-tax income is utilized since taxes are deducted. This indicates that the absolute number of profits may be applied to the interest payment at some future date. Similar to the interest coverage ratio, the better the ratio, the higher the number.
Fixed-Charge Coverage Ratio = (Earnings Before Interest and Taxes + Fixed Charges Before Tax) / (Fixed Charges Before Tax + Interest)
Asset coverage Ratio
The asset coverage ratio determines how well a business can pay off its debt by liquidating its assets.
It deals with all the aggregated assets of the business, not only the liquid ones. It is the most effective technique for stakeholders to assess a company’s solvency.
Asset Coverage Ratio = ((Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) / Total Debt
Things like goodwill are regarded as intangible assets. Obligations that are due within a year are categorized as current liabilities. The same period is used for short-term debt as well.
The better a corporation can pay off its debt, the higher the ratio. As a result, a corporation will find it harder to pay off its debt if the ratio is smaller.
The Risks of High Leverage
Recognizing the dangers associated with excessive leverage relies on the kind of leverage being examined. Earnings tend to be multiplied through leverage, but the peril also increases. Though companies aim for a high financial and operating leverage, possessing both may be a little riskier for a company.
A corporation with high operating leverage is likely not making as many sales as it should. Additionally, it indicates that despite low sales volume, businesses face substantial costs. As a result, less money is available to pay for other expenses. Additionally, it causes negative earnings, which no corporation wants.
When ROI is insufficient to pay the interest on loans, there is high financial leverage. This lowers a company’s earnings per share as well as its competitiveness. The coexistence of these two ratios indicates impending default.
Few businesses are equipped to handle both. They aren’t inherently harmful on their own. They are a formula for disaster when combined.
Reference
- Leverage Ratio Definition (investopedia.com)
- Leverage Ratio with Formula and Examples (cleartax.in)
- Leverage Ratios Formula | Step by Step Calculation with Examples (wallstreetmojo.com)
- What Are Leverage Ratios? – Types, Formula, How to Calculate (khatabook.com)
- What Is a Leverage Ratio? Definition, Calculation, and Examples – TheStreet
Leave a Reply