What is the Leverage Ratio Formula?
Leverage ratios show how much debt a company holds in relation to other equity and assets. Leverage ratio formulas exist in several forms and are designed to help determine the stability and security of a company.
When a company is heavily leveraged, it might mean that they’re carrying much more debt than they’re able to service, and it puts them at increased risk of insolvency.
Leverage, in the financial world, is the amount of debt a company holds compared to its stock or book value. Companies often use leverage as a way to potentially increase their value by borrowing money for projects, investments, and other business growth purposes.
Types of leverage ratios
Leverage ratios are types of financial ratios that come in several forms, and the calculations are simple and direct. Investors, analysts, and lenders often look at one or more of these ratios to determine a company’s long term viability. Leverage ratios include debt to equity, equity multiplier, debt-to-capitalization ratio, and debt-to-capital ratio.
What is a debt ratio?
Debt ratio compares the value of assets to the outstanding debt. Simply divide the total amount of debt by the total value of the assets.
Debt to assets ratio = debt / assets
Let’s say a new company just recently opened its doors and has all new equipment. It has $10,000 in total assets and $50,000 in debt. Its debt ratio is 500%.
An established company might have $50M in assets and $30M in debt. This company’s debt ratio is just 60%.
A high debt to asset ratio can mean that most of the company’s assets were financed instead of purchased outright, or it could mean that the assets were used as collateral for new debt. Generally, high debt ratios are a cause for concern, because most investors aren’t certain the company can generate enough income to cover the debt.
What is the debt to equity ratio?
Equity is the total amount of a company’s assets minus its liabilities. A debt to equity ratio compares the amount of debt the company holds against the amount of equity it has.
Debt to equity ratio = total debt / total equity
A high debt to equity ratio might mean the owners of the business aren’t offering enough equity to finance the business.
An equity multiplier often goes in hand with the debt to equity leverage ratio, as it is a ratio that compares the company’s total assets against assets owned by the shareholders. If the equity multiplier is low, it indicates the company is financing its needs with shareholder funds instead of incurring more debt.
How and why is leverage created?
Most businesses have several ways to increase leverage. Perhaps the most common option is to take on debt through direct loans, a revolving line of credit, and similar means. Other options include financing equipment, using existing assets as collateral, and selling common stock.
Companies acquire debt as a way to fuel growth, which is why it’s referred to as leverage. Without the extra leverage, they may not be able to grow as quickly, acquire new technology needed for advancement, or research and develop new products.
What is the relevance and use of the leverage ratio?
The leverage ratios concept is important from the vantage point of the lender. It helps to measure the risk of a borrower not being able to pay back the debts it acquires.
However, some amount of leverage can be viewed as beneficial to shareholders. This is because it reveals how the business is making use of equity to finance its operations. This transparency creates goodwill and eventually may bring about an increase in the return on equity for their current shareholders.
Assessing a company's leverage ratios is an excellent step in analyzing risk from both a lending and investing perspective. It can also be a useful way to see what future plans a company holds. Keep in mind that each leverage ratio formula focuses on individual areas of the company, which may not include other overall information and details.