What Is a Leverage Ratio?

A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans) or assesses the ability of a company to meet its financial obligations. The leverage ratio category is important 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 as they come due.聽Several common leverage ratios are discussed below.

  • A leverage ratio is any one of several financial measurements that assesses the ability of a company to meet its financial obligations.
  • A leverage ratio may also be used to measure a company's mix of operating expenses to get an idea of how changes in output will affect operating income.聽
  • Common leverage ratios include the debt-equity ratio, equity multiplier, degree of financial leverage, and consumer leverage ratio.
  • Banks have regulatory oversight on the level of leverage they are can hold.

Understanding The Leverage Ratio

What Does a Leverage Ratio Tell You?

Too much debt can be dangerous for a company and its investors. However, if a company's operations can generate a higher rate of return than the interest rate on its loans, then the debt may help to fuel growth. Uncontrolled debt levels can lead to credit downgrades or worse.聽On the other hand, too few debts can also raise questions. A reluctance or inability to borrow may be a sign that operating margins are tight.

There are several different ratios that may be categorized as a leverage ratio, but the main factors considered are debt, equity, assets, and interest expenses.

A leverage ratio may also be used to measure a company's mix of operating expenses to get an idea of how changes in output will affect operating income. Fixed and variable costs are the two types of operating costs; depending on the company and the industry, the mix will differ.聽

Finally, the consumer leverage ratio refers to the level of consumer debt compared to disposable income and is used in economic analysis and by policymakers.

Banks and Leverage Ratios

Banks are among the most聽leveraged聽institutions in the United States. The combination of聽fractional-reserve banking聽and聽Federal Deposit Insurance Corporation聽(FDIC) protection has produced a banking environment with limited lending risks.

To compensate for this, three separate regulatory bodies, the FDIC, the聽Federal Reserve,聽and the聽Comptroller of the Currency, review and restrict the leverage ratios聽for American banks.锘 This means they restrict how much money a bank can lend relative to how much capital the bank devotes to its own assets. The level of capital is important because banks can "write down" the capital portion of their assets if total asset values drop. Assets financed by debt cannot be written down because the bank's bondholders and depositors are owed those funds.

Banking聽regulations for leverage ratios are complicated. The Federal Reserve created guidelines for聽bank holding companies, although these restrictions vary depending on the rating assigned to the bank. In general, banks that experience rapid growth or face operational or financial difficulties are required to maintain higher leverage ratios.

There are several forms of聽capital requirements聽and minimum聽reserve placed on American banks through the FDIC and the Comptroller of the Currency that indirectly impacts leverage ratios. The level of scrutiny paid to leverage ratios has increased since the Great Recession of 2007 to 2009 when banks that were "too big to fail" were a calling card to make banks more solvent. These restrictions naturally limit the number of loans made because it is more difficult and more expensive for a bank to raise capital than it is to borrow funds. Higher capital requirements can reduce dividends or dilute share value if more聽shares聽are issued.

For banks, the tier 1 leverage ratio is most commonly used by regulators.

Leverage Ratios for Evaluating Solvency and Capital Structure

Perhaps the most well known financial leverage ratio is the debt-to-equity ratio.

The Debt-to-Equity (D/E) Ratio

This is expressed as:

Debt-to-Equity聽Ratio=Total聽LiabilitiesTotal聽Shareholders鈥櫬燛quity\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Total Shareholders' Equity}}Debt-to-Equity聽Ratio=Total聽Shareholders鈥櫬燛quityTotal聽Liabilities

For example, United Parcel Service's聽long-term debt for the quarter ending December 2019聽was聽$21.8 billion. United Parcel Service's total stockholders' equity for the ending December 2019 was聽$3.3 billion. The company's D/E for the聽quarter was . That is considered high.

A high debt/equity ratio generally indicates that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If the company's interest expense grows too high, it may increase the company's chances of a default or bankruptcy.

Typically, a D/E ratio greater than 2.0 indicates a risky scenario for an investor; however, this yardstick can vary by industry. Businesses that require large capital expenditures (CapEx), such as utility and manufacturing companies, may need to secure more loans than other companies. It's a good idea to measure a firm's leverage ratios against past performance and with companies operating in the same industry to better understand the data. Fedex has a D/E ratio of 1.78, so there is cause for concern where UPS is concerned. However, most analysts consider that UPS earns enough cash to cover its debts.

The Equity Multiplier

The equity multiplier is similar, but replaces debt with assets in the numerator:聽

Equity聽Multiplier=Total聽AssetsTotal聽Equity\text{Equity Multiplier} = \frac{\text{Total Assets}}{\text{Total Equity}}Equity聽Multiplier=Total聽EquityTotal聽Assets

For example, assume that Macy's (NYSE: M) has assets valued at $19.85 billion and stockholder equity of $4.32 billion. The equity multiplier would be:

$19.85聽billion$4.32聽billion=4.59\$19.85 \text{ billion} \div \$4.32 \text{ billion} = 4.59$19.85聽billion$4.32聽billion=4.59

Although debt is not specifically referenced in the formula, it is an underlying factor given that total assets includes debt.

Remember that Total Assets = Total Debt + Total shareholders' Equity. The company's high ratio of 4.59 means that assets are mostly funded with debt than equity. From the equity multiplier calculation, Macy's assets are financed with $15.53 billion in liabilities.

The equity multiplier is a component of the DuPont analysis for calculating return on equity (ROE):聽聽聽聽聽聽聽

DuPont聽analysis=NPMATEMwhere:NPM=net聽profit聽marginAT=asset聽turnoverEM=equity聽multiplier\begin{aligned} &\text{DuPont analysis} = NPM \times AT \times EM\\ &\textbf{where:}\\ &NPM=\text{net profit margin}\\ &AT=\text{asset turnover}\\ &EM=\text{equity multiplier}\\ \end{aligned}DuPont聽analysis=NPMATEMwhere:NPM=net聽profit聽marginAT=asset聽turnoverEM=equity聽multiplier

The Debt-to-Capitalization Ratio

An indicator that measures the amount of debt in a company鈥檚 capital structure is the debt-to-capitalization ratio, which measures a company鈥檚 financial leverage. It is calculated as:

Total聽debt聽to聽capitalization=(SD+LD)(SD+LD+SE)where:SD=short-term聽debtLD=long-term聽debtSE=shareholders鈥櫬爀quity\begin{aligned} &\text{Total debt to capitalization} = \frac{(SD + LD)}{(SD + LD + SE)}\\ &\textbf{where:}\\ &SD=\text{short-term debt}\\ &LD=\text{long-term debt}\\ &SE=\text{shareholders' equity}\\ \end{aligned}Total聽debt聽to聽capitalization=(SD+LD+SE)(SD+LD)where:SD=short-term聽debtLD=long-term聽debtSE=shareholders鈥櫬爀quity

In this ratio, operating leases are capitalized and equity includes both 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 firm's capital structure. The formula, in this case, would include minority interest and preferred shares in the denominator.

Degree of Financial Leverage聽

Degree of financial leverage (DFL) is a ratio that measures the sensitivity of a company鈥檚 earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. It measures the percentage change in EPS for a unit change in earnings before interest and taxes (EBIT) and is represented as:

DFL=%聽change聽in聽EPS%聽change聽in聽EBITwhere:EPS=earnings聽per聽shareEBIT=earnings聽before聽interest聽and聽taxes\begin{aligned} &DFL = \frac{\% \text{ change in }EPS}{\% \text{ change in }EBIT} \\ &\textbf{where:}\\ &EPS=\text{earnings per share}\\ &EBIT=\text{earnings before interest and taxes}\\ \end{aligned}DFL=%聽change聽in聽EBIT%聽change聽in聽EPSwhere:EPS=earnings聽per聽shareEBIT=earnings聽before聽interest聽and聽taxes

DFL can alternatively be represented by the equation below:

DFL=EBITEBITinterestDFL = \frac{EBIT}{EBIT - \text{interest}}DFL=EBITinterestEBIT

This ratio indicates that the higher the degree of financial leverage, the more volatile earnings will be. Since interest is usually a fixed expense, leverage magnifies returns and EPS. This is good when operating income is rising, but it can be a problem when operating income is under pressure.

The Consumer Leverage Ratio

The consumer leverage ratio is used to quantify the amount of debt the average American consumer has relative to their聽disposable income.

Some economists have stated that the rapid increase in consumer debt levels聽has been a contributing factor to corporate earnings growth over the past few decades. Others blamed the high level of consumer debt as a major cause of the great recession.

Consumer聽leverage聽ratio=Total聽household聽debtDisposable聽personal聽income\text{Consumer leverage ratio} = \frac{\text{Total household debt}}{\text{Disposable personal income}}Consumer聽leverage聽ratio=Disposable聽personal聽incomeTotal聽household聽debt

Understanding how debt amplifies returns is the key to understanding leverage. Debt is not necessarily a bad thing, particularly if the debt is taken on to invest in projects that will generate positive returns. Leverage can thus multiply returns, although it can also magnify losses if returns turn out to be negative.

The Debt-To-Capital Ratio

The聽debt-to-capital ratio聽is a measurement of a company's financial leverage. It is one of the more meaningful聽debt ratios聽because it focuses on the relationship of debt liabilities as a component of a company's total capital base. Debt includes all short-term and long-term obligations. Capital includes the company's debt and shareholders' equity.

This ratio is used to evaluate a firm's聽financial structure聽and how it is financing operations. Typically, if a company has a high debt-to-capital ratio compared to its peers, it may have a higher聽default risk聽due to the effect the debt has on its operations. The oil industry seems to have about a 40% debt-to-capital threshold. Above that level, debt costs increase considerably.

The聽Debt-To-EBITDA聽Leverage Ratio

The聽debt-to-EBITDA聽leverage ratio measures a company's ability to pay off its incurred debt. Commonly used by聽credit agencies, this ratio determines the probability of defaulting on issued debt. Since oil and gas companies typically 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 back all the debt. Typically, it can be alarming if the ratio is over 3, but this can vary depending on the industry.

The Debt-To-EBITDAX聽Ratio

Another variation of the debt-to-EBITDA ratio is the debt-to-EBITDAX聽ratio, which is similar, except EBITDAX is EBITDA before exploration costs for successful efforts companies. This ratio is commonly used in the United States to normalize different accounting treatments for exploration expenses (the full cost method versus the successful efforts method).

Exploration costs are typically found in the聽financial statements聽as exploration, abandonment, and dry hole costs. Other noncash expenses that should be added back in are impairments, accretion of聽asset retirement obligations,聽and deferred taxes.

The Interest Coverage Ratio

Another leverage ratio concerned with interest payments is the interest coverage ratio. One problem with only reviewing the total debt liabilities for a company is they do not tell you anything about the company's ability to service the debt. This is exactly what the interest coverage ratio aims to fix.

This ratio, which equals operating income divided by interest expenses, showcases the company's ability to make interest payments. Generally, a ratio of 3.0 or higher is desirable, although this varies from industry to industry.

The Fixed-Charge Coverage Ratio

Times interest earned (TIE), also known as a fixed-charge coverage ratio, is a variation of the interest coverage ratio. This leverage ratio attempts to highlight cash flow relative to interest owed on long-term liabilities.

To calculate this ratio, find the company's聽earnings before interest and taxes聽(EBIT), then divide by the interest expense of long-term debts. nba腾讯体育直播e pre-tax earnings because interest is tax-deductible; the full amount of earnings can eventually be used to pay interest. Again, higher numbers are more favorable.