From the realm of finance and investing, understanding risk and its returns is of utmost importance. One of the most critical components in defining financial risk is the leverage ratio. Whether you’re an investor examining a firm, a student studying financial ratios, or a business owner balancing your debt, leverage ratios provide you with the risk an organisation is assuming when it has debt obligations.
In this complete guide, we will answer the question of what is leverage ratio, its meaning, how it is calculated, its importance and its types, and real world practical examples in a clear, precise and simple manner.
What Is Leverage Ratio?
The leverage ratiois a metric used to assess how much debt a business holds in comparison to its equity or total assets. Put simply, it is an indicator of how much of a business is operationally dependent on external financing.
When a firm raises money through loans, bonds, or other types of borrowings, it is called using leverage. Leverage can be a double-edged sword, boosting profits during economic expansion but also increasing risks for the firm in economic downturns.
To best answer the question, what is a leverage ratio, look at the following statement:
A leverage ratio is a measure of the amount of debt that the company has in comparison to its own funds or assets.
Why Does Leverage Ratio Have Value to a Company?
Most companies need leverage to be financially stable, so it is a juggling act to keep the ratios in check. Investors use leverage ratios to determine the company’s ability to withstand economic downturns. The ratios are also useful to lenders who are evaluating the company’s ability to service the debt. For management of the company, the ratios are a guide to how much debt is prudent and how much growth will occur.
A company can be in trouble for excessively high leverage when rates are increasing and revenues are declining. A company can be in trouble for very low leverage when growth opportunities are being passed up.
How Leverage Ratio Works (the simplified version)
Consider two companies that are making the same profit:
- Company A has mostly its own money.
- Company B has a significant amount of borrowed funds.
Company B could get greater returns due to debt profits. However, Company B would still have to service the debt, which increases the chances of losses. This is the type of analysis that is assisted by leverage ratios.
Leverage Ratio Types
Because there are different types of leverage ratios, there won't be a singular one for a specific analysis. Each type of leverage ratio has a different focus pertaining to the type of debt and the structure of finances at a company. Here, you will find the most commonly used types of leverage ratios.
Debt-to-Equity Ratio
This is the ratio that gives the most fundamental analysis of a company’s debt and how much equity is in the financing. The debt-to-equity ratio is a measure of a company’s total debt and the corresponding shareholders’ equity. This ratio tells us how much debt there is for every unit of equity provided.
Debt financing is what drives a business to take on excessive risk, and this is the ratio that will most tell investors whether a business is dangerously debt-financed.
Debt Ratio
This ratio encompasses total assets and tells how much of that is financed by debt. The debt ratio is a measure of the company’s total assets that are financed by debt, which gives a fair measure of the financial risk.
Equity Ratio
The equity ratio measures the company’s total assets that are financed by the shareholders. This is the opposite of the debt ratio and states how much of the total assets are financed by the shareholders’ funds.
Interest Coverage Ratio
The interest coverage ratio is used in conjunction with other types of leverage ratios. However, it is a different type of measure because it focuses on a company's ability to cover interest payments on debt with operating profits.
It addresses an important question: Does the company have enough cash to cover interest costs?
Leveraging Ratio Formulas
Let us attempt to understand the leveraging ratio formulas for each of the main types in an uncomplicated manner.
Debt-to-Equity Ratio Formula
Debt to Equity Ratio = Total Debt ÷ Equity of the Shareholders
This formula is a reflection of the amount of debt in proportion to the amount of equity.
Debt Ratio Formula
Debt Ratio = Total Debt ÷ Total Assets
This formula indicates the portion of the company's assets that are financed through debt.
Equity Ratio
Equity Ratio = Shareholders’ Equity ÷ Total Assets
This formula indicates the level of funding provided by the owners into the business.
Formula for Interest Coverage Ratio
Interest Coverage Ratio = EBIT ÷ Interest Expense
This ratio shows how many times a business is able to cover interest payments from profits made from normal business activities.
Leverage Ratio Examples (Easy to Understand)
To understand the concept better, let’s navigate through some examples of leverage ratios.
Example 1: Debt-to-Equity Ratio
Consider a firm which has total debt of ₹50 crore and shareholders’ equity of ₹100 crore.
Debt-to-Equity Ratio = 50 ÷ 100 = 0.5
This means the company has ₹0.50 of debt for every ₹1 of equity. This is generally considered a healthy level of leverage.
Debt-to-Equity Ratio = 0.5 = Healthy level of leverage
Example 2: Debt Ratio
Consider a company with total assets of ₹200 crore and total debt of ₹80 crore.
Debt Ratio = 80 ÷ 200 = 0.40
This means 40% of the firm’s assets are financed by debt and the remainder is financed by equity.
Debt Ratio = 0.40 = 40% of the assets are financed by debt = 60% of the assets are financed by equity
Example 3: Interest Coverage Ratio
If a company has EBIT of ₹30 crore and interest expenses of ₹5 crores:
Interest Coverage Ratio = 30 ÷ 5 = 6
This means the company can pay its interest expense 6 times, so the company has a strong financial safety.
Interest Coverage Ratio = 6 = Strong financial safety.
What is a good leverage ratio?
There is no 'perfect' leverage ratio, as every industry and every model and every prevailing economic condition makes it different. Higher leverage is common for capital-intensive industries like telecom, power and infrastructure, while lower leverage is common for asset-light industries like IT and FMCG.
Generally speaking:
- Lower leverage ratios. Lower financial risk.
- Greater financial risk. Higher bankruptcy risk during downturns. Could be an inefficient use of capital. Extreme low leverage.
Quick Comparison of Leverage Ratio and Liquidity Ratio
Leverage ratios measure how much financial risk and long-term debt structure an organisation possesses. While liquidity ratios measure how short-term an organisation is able to pay its obligations.
They both matter. But for long-term investors and creditors, leverage ratios carry greater weight.
Why Use Leverage Ratios
Knowing leverage ratios makes it easier for investors and analysts to generate comparisons between similar companies in the same industry. It helps them know if profit is a result of too much borrowing or a solid operational profit generator.
Leverage ratios also tell analysts how stressed a business may be financially, especially when interest rates are high.
Why Leverage Ratios are Less Reliable
Leverage ratios must never be the only ratios you use. They never consider the quality of managers, the timing of cash flows, or the company’s potential growth in the future.
The way the company is run can also distort how debt and equity are reported, which can affect how accurate the leverage ratios are.
How Investors Should Use Leverage Ratios
The most effective way to assess a company's risk and return is to combine leverage and profitability ratios with cash flow analysis, and, ideally, industry analysis. A company with moderate leverage, stable cash flow, and consistently strong profitability is likely to provide a better investment return than a company with high leverage and volatile profitability.
Final Thoughts
If you work in investing, business analysis, or finance, learning what a leverage ratio is, is non-negotiable. The financial ratios that measure the risk a firm undertakes and the potential consequences of that risk are called leverage ratios.
The more you study the different types of leverage ratios, learn the formulas for each type of leverage ratio, and work through real leverage ratio examples, the better financial decisions you'll make and the more mistakes you'll avoid.
DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.
