What is a leverage ratio?
A leverage ratio is any one of several financial measures that examine the amount of capital in the form of debt (loans) or assess a company’s ability to meet its financial obligations. The leverage ratio category is important because businesses rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a business is useful in assessing whether it can repay its debts to their deadline. Several common leverage ratios will be discussed below.
Understanding the leverage ratio
What does a leverage ratio tell you?
Too much debt can be dangerous for a business and its investors. However, if a company’s operations can generate a higher rate of return than the interest rate on its loans, debt helps to drive profit growth. However, uncontrolled debt levels can lead to credit downgrades or worse. On the other hand, too little debt can also raise questions. A reluctance or inability to borrow can be a sign that operating margins are simply too tight.
There are several different specific ratios that can be classified as a leverage ratio, but the main factors taken into account are debt, equity, assets and interest expense.
A leverage ratio can also be used to measure the composition of a company’s operating expenses to get an idea of how changes in production will affect operating profit. Fixed and variable costs are the two types of operating costs; depending on the company and industry, the composition will be different.
Finally, the consumer debt ratio refers to the level of consumer debt relative to disposable income and is used in economic analysis and by policy makers.
Banks and leverage ratios
Banks are among the most leveraged institutions in the United States. The combination of fractional reserve banks and the Federal Insurance Insurance Corporation (FDIC) has created a banking environment with limited lending risks.
To compensate for this, three separate regulators, the FDIC, the Federal Reserve and the Currency Monitor, are examining and restricting leverage ratios for US banks. This means that they restrict the amount of money a bank can lend relative to the capital it spends on its own assets. The level of capital is important because banks can “depreciate” the capital part of their assets if the total value of the assets drops. Debt-funded assets cannot be written down because bondholders and bank depositors owe these funds.
The banking regulations for leverage ratios are very complicated. The Federal Reserve has created guidelines for bank holding companies, although these restrictions vary depending on the bank’s rating. In general, banks that experience rapid growth or encounter operational or financial difficulties are required to maintain higher leverage ratios.
There are several forms of capital requirements and minimum reserve radios placed on US banks through the FDIC and the currency monitor, which have an indirect impact on leverage ratios. The level of control of leverage ratios has increased since the Great Recession of 2007-2009, with the fear that the big banks are “too big to fail” serving as a business card to make the banks more solvent. These restrictions naturally limit the number of loans granted because it is more difficult and more expensive for a bank to raise capital than to borrow funds. Higher capital requirements may reduce dividends or dilute the value of the shares if more shares are issued.
For banks, the level 1 leverage ratio is most commonly used by regulators.
- A leverage ratio is any one of several financial measures that examine the amount of capital in the form of debt (loans) or assess a company’s ability to meet its financial obligations.
- A leverage ratio can also be used to measure the composition of a company’s operating expenses to get an idea of how changes in production will affect operating profit.
- Common leverage ratios include the debt ratio, the equity multiplier, the degree of financial leverage and the consumer leverage ratio.
- Banks exercise regulatory oversight over the level of leverage available to them, measured by leverage ratios.
Leverage ratios to assess solvency and capital structure
The debt / equity ratio (D / E)
Perhaps the best known financial debt ratio is the debt ratio. It is expressed as:
Debt-to-equity ratio=Total equityTotal responsibilitiesTheThe
For example, Macy’s has debt of $ 15.53 billion and equity of $ 4.32 billion at the end of fiscal 2020. The company’s debt ratio is as follows:
$15.53 billion÷$4.32 billion=3.59Macy’s liabilities represent 359% of equity, which is very high for a retail business.
A high debt / equity ratio generally indicates that a company has been aggressive in financing its growth through debt. This can lead to volatile profits due to the additional interest charges. If the interest owed by the business increases too much, it can increase the risk of bankruptcy or bankruptcy of the business.
Typically, a D / E ratio greater than 2.0 indicates a risky scenario for an investor; however, this criterion may vary by industry. Companies that require large capital expenditures (CapEx), such as utility and manufacturing companies, may need to get more loans than other companies. It is a good idea to measure a company’s leverage ratios compared to past performance and with companies operating in the same industry to better understand the data.
The equity multiplier
The equity multiplier is similar, but replaces debt with assets in the numerator:
Equity multiplier=Total equityTotal assetsTheThe
For example, suppose Macy’s (NYSE: M) has assets valued at $ 19.85 billion and equity of $ 4.32 billion. The equity multiplier would be:
$19.85 billion÷$4.32 billion=4.59The
Although debt is not specifically mentioned in the formula, it is an underlying factor since total assets include debt.
Do not forget that Total assets = total debt + total equity. The company’s high ratio of 4.59 means that the assets are mainly financed by debt rather than by equity. According to the equity multiplier calculation, Macy’s assets are funded by a liability of $ 15.53 billion.
The equity multiplier is a component of the DuPont analysis for the calculation of return on equity (ROE):
TheDuPont Analysis=NOTPM×AT×EMor:NOTPM=net profit marginAT=asset rotationEM=equity multiplierTheThe
The debt / capitalization ratio
One indicator that measures the amount of debt in a company’s capital structure is the debt-to-capitalization ratio, which measures a company’s financial leverage. It is calculated as:
TheTotal debt at capitalization=(Sre+There+SE)(Sre+There)Theor:Sre=short-term debtThere=long-term debtSE=equityTheThe
In this ratio, operating leases are capitalized and equity includes common and preferred shares. Instead of using long-term debt, an analyst may decide to use total debt to measure the debt used in a company’s capital structure. In this case, the formula would include minority interests and preferred shares in the denominator.
Degree of financial leverage
The degree of financial leverage (LDF) is a ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating profit, due to changes in its capital structure. It measures the percentage change in EPS for a unit change in profit before interest and taxes (EBIT) and is represented as follows:
ThereFThe=% switch EBIT% switch EPSTheor:EPS=earnings per shareEBIT=earnings before interest and taxesTheThe
The LDF can also be represented by the equation below:
This ratio indicates that the higher the level of financial leverage, the more volatile the profits. Since interest is usually a fixed expense, leverage increases returns and EPS. It’s a good thing when operating profit increases, but it can be a problem when operating profit is under pressure.
The consumer leverage ratio
The consumer leverage ratio is used to quantify the amount of debt of the average American consumer, relative to their disposable income.
Some economists have said that the rapid increase in consumer debt levels has been a major factor in the growth of corporate profits in recent decades. Others have accused the high level of consumer debt as a major cause of the Great Recession.
Consumer leverage ratio=Personal disposable incomeTotal household debtTheThe
Understanding how debt boosts returns is key to understanding leverage, but as you can see, it comes in many forms of analysis. Debt in itself is not necessarily a bad thing, especially if the debt is contracted to make larger investments in projects that will generate positive returns. Leverage can therefore multiply returns, but it can also amplify losses if returns turn out to be negative.
The debt-to-capital ratio is a measure of a company’s financial leverage. This is one of the most significant debt ratios, as it focuses on the relationship between debts and debts as a component of the total capital of a business. Debt includes all short and long term obligations. The capital includes the company’s debt and equity.
This ratio is used to assess the financial structure of a business and how it finances its operations. In general, if a company has a high debt to peer ratio, it may have a higher risk of default due to the effect of debt on its operations. The petroleum industry seems to have a debt threshold of around 40%. Above this level, the cost of debt increases considerably.
The debt / EBITDA leverage ratio
The debt / EBITDA leverage ratio measures a company’s ability to repay its contracted debt. Commonly used by credit agencies, it determines the probability of default on the debt issued. Since oil and gas companies generally have a lot of debt on their balance sheets, this ratio is useful in determining how many years of EBITDA would be required to pay off all of the debt. Generally, it can be alarming if the ratio is greater than 3, but this can vary by industry.
The debt / EBITDAX ratio
Another variation of the debt / EBITDA ratio is the debt / EBITDAX ratio, which is similar, except that EBITDAX is EBITDA before exploration costs for successful companies. In the United States, this ratio is commonly used to standardize different accounting treatments for exploration expenses (the full cost method versus the successful effort method).
Exploration costs are generally found in the financial statements in the form of exploration costs, abandonment and dry holes. Other non-cash charges that should be added are impairments, accretion of obligations related to asset retirement and deferred taxes.
The interest coverage ratio
Another leverage ratio affected by interest payments is the interest coverage ratio. One problem with examining the total debt liabilities of a business is that they tell you nothing about the ability of the business to repay the debt. This is exactly what the interest coverage ratio aims to correct.
This ratio, which is equivalent to operating profit divided by interest expense, highlights the company’s ability to make interest payments. You generally want to see a ratio of 3.0 or higher, although this varies from industry to industry.
Coverage rate for fixed costs
The earned interest rate (EIR), also known as the fixed cost coverage rate, is a variation of the interest coverage rate. This leverage ratio attempts to highlight cash flows relative to interest due on long-term liabilities.
To calculate this ratio, find the company’s profit before interest and taxes (EBIT), and then divide it by interest expense on long-term debt. Use pre-tax profits because interest is tax deductible; the total amount of the winnings can possibly be used to pay interest. Again, higher numbers are more favorable.