Leverage ratio

Leverage ratio

Various financial measures are frequently used to assess a company’s economic success. They cover every facet of the company’s financial situation by concentrating on several criteria. The financial soundness of a corporation is expressed using leverage ratios in terms of the amount of debt it has. 

When looking for money, whether a loan from a bank or a venture capitalist, leverage ratios are particularly crucial. Leverage ratios are helpful indications for both banks and businesses of how their assets are financed, whether through debt or equity. Since it’s an evaluation of how readily a firm can satisfy financial obligations, it’s also a helpful indicator for market analysts and investors. 

What is leverage ratio? 

Any financial ratio known as a leverage ratio shows how much debt an organisation has taken on other accounts on its balance sheet, income statement, or cash flow statement. These ratios reveal how the organisation finances its assets and commercial operations (using debt or equity). 

Even though debt builds capital, investors view it more as a liability. A corporation employs more debt than equity to develop its resources when its leverage ratio is larger. Additionally, more severe consequences, such as bankruptcy, may result when debt levels are higher.

Understanding leverage ratio 

Leverage ratios are a group of ratios that show how financially leveraged a company handles its assets, liabilities, and equity. They reveal how much of an organisation’s capital is derived from debt, which is a reliable indicator of whether a company can honour its financial commitments. 

 A firm that uses debt to finance its assets and operations will have a higher financial leverage ratio. It is frequently a red flag for potential investors that the company might not be a safe investment. It could imply erratic earnings, and a long wait before shareholders receive a significant return on their investment or even the imminent insolvency of the company. 

 Creditors also use these criteria to determine whether to extend loans to businesses. If a company’s financial leverage ratio is too high, most of its cash flow is directed towards paying down debt, which increases the risk of loan default. A corporation is often more financially responsible if it has a steady income stream and a lower financial leverage ratio. A high financial leverage ratio indicates to potential investors and credit-rating companies that a company is risk-free and worthwhile, even if the parent company is saddled with huge debt.

The formula of the leverage ratio 

The information that investors have access to determines how leverage ratios are calculated. They calculate the percentage and contrast the financial responsibility with the capital a company has built, according to their specifics. 

The most commonly used leverage ratios are: 

• Debt-to-assets ratio = Total debt / Total assets 

• Debt-to-equity ratio = Total debt / Total equity 
• Asset-to-equity ratio = Total assets / Total equity 
• Debt-to-capital ratio = Today Debt / (Total Debt + Total Equity) 
• Debt-to-EBITDA Ratio = Total Debt / Earnings before interest taxes, depreciation & amortisation 

Types of leverage ratio 

There are two main categories of leverage ratios: 

• Capital structure ratio 

The capital structure ratio is employed to decide the financing strategy for the business to concentrate on long-term solvency. 

The following ratios are included in the capital structure ratio: 

• The equity ratio 
• The debt ratio 
• The debt-to-equity ratio

• Coverage ratios 

Coverage ratios assess a company’s capacity to pay dividends and interest on its debt and other debt-related obligations. It is simpler for a company to pay off dividends and interest payments when the coverage ratio is larger. 

The coverage ratio includes the following ratios: 

• The ratio of debt service to income 
• The ratio of interest coverage
• The ratio of capital to debt 

Importance of leverage ratio 

Leverage ratios provide information on how much debt a company is using. It also assesses the company’s solvency and capital structure. High leverage can be hazardous and advantageous in a corporation’s capital structure. 

When a company is making money, using leverage helps to magnify those earnings. On the other hand, a highly leveraged company may struggle if its profitability drops and may run a higher risk of default than an unlevered or less leveraged company in the same circumstances. When a company wants to seek more borrowing, creditors consider the amount of debt it currently has. Leverage increases risk, but if everything works well, it produces a profit. 

Frequently Asked Questions