A leverage ratio is a business finance term that refers to any one of several different ratios that measure the level of debt, or amount of financial leverage, that a business is using to finance its operations. Investors use leverage ratios to gain a better understanding of the debt burden a business is under.
Understanding Leverage Ratios
In finance, leverage is a term that refers to the use of debt to raise capital with the expectation that this capital can generate a gain that will exceed the cost of the debt. As in the physical science application of the term, leverage can enable its user to carry or move a heavier load than they could without the use of the lever.
For example, many financial leverage ratios measure a company’s debt as it compares to its assets. The leverage ratios generally tell the company’s management, stock shareholders, and other stakeholders how much risk the company has within its capital structure.
Important: Using debt to raise capital and finance a company’s projects or operations does not come without its risk. For this reason, business analysts and investors use leverage ratios to determine if a company’s debt load is potentially helping or hindering its growth. Too much debt can be too risky, whereas using too little debt can get in the way of growth or even indicate an inability find lenders, possibly due to poor profitability.
Leverage Ratios in Banking
The banking industry is one of the most highly leveraged industries in the United States. For this reason, and because they are an essential component of the U.S. economy, banks are also among the most regulated businesses. For regulatory purposes, the federal government will periodically review the leverage ratios of banks.
The regulatory bodies that monitor bank leverage ratios are the Federal Reserve, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (FDIC). Capital requirements and minimum reserve requirements, especially since the Great Recession of 2007 to 2009, have raised the scrutiny of banking leverage ratios.
The most commonly used leverage ratio used for banks is the Tier 1 Leverage Ratio, which compares a bank’s Tier 1 capital to its total assets. Tier 1 capital is a measure of a bank’s assets that can be easily liquidated in the event of a financial crisis.
Leverage Ratio Types, Formulas & Examples
There are several different types of leverage ratios used in measuring how much of a company’s capital comes in the form of debt. A company’s management, investors, and other stakeholders can use these ratios to assess the ability of a company to meet its financial obligations.
Here are the 9 main types of leverage ratios:
- Equity Multiplier
- Debt-to-Equity (D/E) Ratio
- Interest Coverage Ratio
- Fixed-Charge Coverage Ratio
- Debt-to-EBIDTA Ratio
- Degree of Financial Leverage
- Consumer Leverage Ratio
- Debt-to-Capital Ratio
- Debt-to-Capitalization Ratio
Equity Multiplier Formula and Example
The equity multiplier is a risk indicator used to measure how much of a company’s operations are financed by stock, rather than debt. Investors generally prefer a lower equity multiplier because this indicates that a company is using more equity and less debt in financing. However, it’s important to note that the use of debt can improve earnings leverage, so companies with low equity multipliers may be foregoing those earnings leverage opportunities due to choice or the inability to obtain debt financing.
Here is the equity multiplier formula:
Equity Multiplier = Total Assets / Total Shareholder Equity
For example, if a company’s total assets on their balance sheet were $50 billion and the book value of their shareholder equity was $10 billion, the equity multiplier would be 5, or $50 billion divided by $10 billion. To determine if this was a good equity multiplier or not, an investor could compare this multiplier to the company’s prior year multiplier or to that of its competitors.
Debt-to-Equity Ratio Formula and Example
The debt-to-equity (D/E) ratio is used to measure how much leverage a company is using by comparing its total liabilities to its shareholder equity. A high D/E ratio indicates that a company has a high level of liabilities, likely including debt, compared to equity. A high D/E ratio is potentially a negative indicator. Debt financing can drive earnings leverage, however, so a low debt-to-equity ratio is not necessarily good and a higher debt-to-equity is not necessarily bad.
Here is the D/E ratio formula:
D/E = Total Liabilities / Total Shareholder Equity
For example, if you look at a company’s balance sheet and find that their total liabilities for a given period were $50 million and their shareholders’ equity was $100 million, the company’s D/E ratio would be 0.5, or $50 million / $100 million.
Interest Coverage Ratio Formula and Example
Sometimes called the Times Interest Earned (TIE) ratio, the interest coverage ratio is a risk measure used to determine how easily a company can pay the interest on its debt. Generally, a higher interest coverage ratio is better, although the ideal ratio can vary from industry to industry.
Here is the interest coverage ratio formula (note that EBIT is earnings before interest and taxes):
Interest coverage = EBIT / Interest Expense
For example, if a company’s EBIT during a given quarter is $30 million and its debt payments per month are $2 million (or $6m quarterly), the interest coverage calculation would be 5x, or $30 million / $6 million.
Fixed-Charge Coverage Ratio Formula and Example
The fixed-charge coverage (FCCR) ratio is used to measure how well a company’s earnings can cover its fixed expenses, such as its interest expense, lease payments, and debt payments. This ratio is commonly used by lenders to assess a company’s creditworthiness.
Here is the fixed-charge coverage ratio formula:
FCCR = (EBIT + FCBT) / FCBT + Interest Expense
EBIT = Earnings Before Interest and Tax
FCBT = Fixed Charges Before Tax
For example, if a company has EBIT of $600,000, lease payments of $400,000, and $100,000 of interest expense, the calculation would be $600,000 plus $400,000 divided by $400,000 plus $100,000. Broken down further, this would be $1 million divided by $500,000, which equals a FCCR of 2x.
Some investors might be curious why FCBT is added back in the numerator of the FCCR calculation. This is because if the intent is to measure a company’s coverage of its fixed charges, the starting point would be prior to subtraction of those costs.
Debt-to-EBITDA Ratio Formula and Example
The debt-to-EBITDA, or debt/EBITDA, ratio measures how much income a company has available to pay its expenses before interest, taxes, depreciation, and amortization (EBITDA) expenses. A lower debt/EBITDA ratio generally indicates that a company has a manageable debt burden.
Here is the debt-to-EBITDA formula:
Debt-to-EBITDA = Debt / EBITDA
For example, if a company’s total debt on their balance sheet is $200 million and it has $20 million in EBITDA, the debt/EBITDA ratio would be 10, $200 million divided by $20 million.
Degree of Financial Leverage Formula and Example
The degree of financial leverage, or DFL, is a leverage ratio that shows how the degree of change in earnings per share is related to fluctuations in its operating income. A company may use DFL to determine if it can safely add more debt to finance a project. A higher DFL generally indicates that earnings will be more volatile.
Here is the degree of financial leverage formula:
DFL = % change in net income / % change in EBIT
Consumer Leverage Ratio Formula and Example
The consumer leverage ratio is a measure of how much total debt the average American household has compared to disposable personal income. As is the case with leverage ratios used on the corporate level, debt can be a good thing for the economy but too much debt can indicate economic weakness.
Here is the consumer leverage ratio formula:
Consumer Leverage = Total Household Debt / Disposable Personal Income
Total debt and personal income are reported by the Federal Reserve. The average consumer leverage ratio is 0.9. An example of a high ratio was in 2007, when the consumer leverage ratio was 1.29. A financial crisis and the Great Recession soon followed.
Debt-to-Income Ratio Formula and Example
Debt-to-income ratio (DTI) measures the amount of monthly debt payments a household or corporation is paying as a percentage of gross monthly income. Lenders use DTI to determine the creditworthiness of a borrower.
Here’s how to calculate debt-to-income:
DTI = Monthly Debt Payments / Gross Monthly Income
For a personal household example, let’s say a couple is applying for a mortgage and the lender requires that the household DTI, including the future mortgage payment, to be below 36% for approving the loan.
The couple has credit card debt and two car loans, totaling $1,000 in monthly payments. The new mortgage payment is estimated to be $1,500 per month. The couple’s total gross household income is $7,500. Their DTI without the mortgage is 13.3%, or $1,000 divided by $7,500. Their DTI with the new mortgage is 33.3%, or $2,500 divided by $7,500.
Debt-to-Capitalization Ratio Formula and Example
The debt-to-capitalization ratio measures a company’s total debt as a percentage of its total capital. Businesses can use debt or equity to raise capital for financing its operations. Having too much debt compared to a company’s capitalization can indicate higher risk of insolvency.
Here is the debt-to-capitalization ratio formula:
Debt-to-Capitalization = Total Debt / (Total Debt + Shareholder Equity)
Note: Total debt equals short-term debt plus long-term debt.
For example, assume a company has short-term debt of $10 million, long-term debt of $40 million, and shareholders equity of $30 million. To calculate the company’s debt-to-capitalization ratio, you’d divide the total debt of $50 million by the total capitalization of $80 million and you’d get a ratio of 0.625. This indicates that 62.5% of the company’s capital is being financed by debt.
Important: When analyzing leverage ratios, it can be valuable to compare these measures to the company’s historic metrics and to the ratios of industry peers.
