What are leverage ratios used for?
A leverage ratio is an important financial metric that measures the level of debt a company has relative to its assets or equity. It is used to assess the financial risk of a company, particularly its ability to meet its debt obligations.
Leverage ratios are important because they help investors and lenders assess a company’s ability to repay its debt obligations. That is because companies rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a company is useful in evaluating whether it can pay off its debts when needed.
A company with a high leverage ratio (too much debt) may be seen as more risky because it has a higher debt burden and may have difficulty servicing its debt in the event of a downturn in the business or the economy.
There are several types of leverage ratios that we will discuss below, but the most commonly used are the debt-to-equity ratio and the debt-to-assets ratio.
The debt-to-equity ratio measures the proportion of a company’s financing that comes from debt compared to equity. The higher the ratio, the more the company is relying on debt to finance its operations.
The debt-to-assets ratio measures the proportion of a company’s assets that are financed by debt.
For example, if a company has a debt-to-equity ratio of 2:1, it means that it has twice as much debt as equity. If it has a debt-to-assets ratio of 0.5, it means that 50% of its assets are financed by debt.
Example of Using Leverage Ratios
If a trucking transportation business has total assets worth $10 million (trucks, warehouses, etc.) – total debt of $3.5 million, and total equity of $6.5 million, then the amount of borrowed money against their total assets is 0.35. This means that much less than half of its total resources are borrowed. A ratio of less than 0.4 is considered good, so in this case the trucking company would be in good financial shape to borrow more.
When calculating these numbers as debt to equity, the ratio for this firm is 0.54 (total debt/ total equity), meaning equity makes up a majority of the firm’s assets.
Based on this information and a number of other factors (the industry, overall economic outlook, current interest rates, etc.), the company or investors might look at the data and decide whether borrowing more is a good idea. As an example, the industries that typically have the highest debt to equity ratios include financial services and utilities, while industries such as wholesale and service industries are examples of those with the lowest debt to equity ratios.
4 Important Leverage Ratios
1) Debt-to-equity ratio
This measures the proportion of a company’s financing that comes from debt compared to equity. A high debt-to-equity ratio indicates that a company is relying heavily on debt to finance its operations, which can be risky if it cannot generate enough cash flow to cover its debt payments.
Debt-to-equity ratio = Total Debt / Total Equity
Total debt is the sum of a company’s short-term and long-term debt. Total equity is the sum of the company’s common stock, preferred stock, and retained earnings.
2) Debt-to-assets ratio
This measures the proportion of a company’s assets that are financed by debt. A high debt-to-assets ratio indicates that a company is heavily reliant on debt financing, which can be a cause for concern if the company’s assets decline in value.
Debt-to-assets ratio = Total Debt / Total Assets
Total debt is the sum of a company’s short-term and long-term debt. Total assets are the sum of a company’s current and non-current assets.
3) Interest coverage ratio
This measures a company’s ability to meet its interest payments on its debt. A higher interest coverage ratio indicates that a company is better able to meet its debt obligations and is less likely to default on its loans.
Interest coverage ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
EBIT is a company’s earnings before interest and taxes. Interest expense is the total amount of interest a company pays on its debt.
4) Operating leverage ratio
This measures the level of fixed costs a company has relative to its variable costs. A higher operating leverage ratio indicates that a company has a higher proportion of fixed costs, which can magnify its profits in good times but can also lead to larger losses in bad times.
Operating leverage ratio = Fixed Costs / (Fixed Costs + Variable Costs)
Fixed costs are costs that do not vary with changes in a company’s level of output, such as rent or salaries. Variable costs are costs that do vary with changes in a company’s level of output, such as materials or labor.
What does the Leverage Ratio say about the business?
As explained above, the leverage ratio is a way of measuring the amount of debt a company has. The higher the ratio, the more the company is relying on debt to finance its operations.
But it’s not so black and white. Depending on the economic period, industry, and investors in the company, a high or low leverage ratio can mean different things.
In general, too much debt can be dangerous for a company – and the investors as well. One bad quarter can put them in a situation where they have to take on even more debt than they wanted to, and uncontrolled debt levels can lead to difficulties in borrowing in the future, or even bankruptcy.
On the other hand, a company with extremely low debts can raise red flags among stakeholders as it seems that they are reluctant to borrow and operating margins are too tight. In addition, if a company is in a situation where they can create a higher rate of return than the interest payments on their loans, then debt can actually help them grow.
In conclusion, in general it is better to have a lower debt to equity ratio, however, there are certain circumstances where it is not always the case.
Using Datarails for calculating Financial Ratios
Every finance department knows how tedious calculating financial ratios for budgeting and forecasting can be. Regardless of the approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
Datarails’ budgeting and forecasting software can help your team create and monitor budgets faster and more accurately than ever before.
By replacing spreadsheets with real-time data and integrating fragmented workbooks and data sources into one centralized location, you can work in the comfort of Excel with the support of a much more sophisticated data management system behind you.