Leverage Ratio Formula

Leverage Ratio Formula (Table of Contents)

• Leverage Ratio Formula
• Examples of Leverage Ratio Formula(With Excel Template)
• Leverage Ratio Formula Calculator

Leverage Ratio Formula

Leverage ratio can be defined as the ratio of total debt to total equity of any firm to understand the level of debt being incurred by any firm or entity.

A Formula of Leverage Ratio can be expressed as:-

Leverage Ratio Formula – Example #1

Let’s take an example of a company X whose Total Debt is $200000 and Total Equity is $300000. Calculate the Leverage Ratio of a company.

Solution:

We can calculate the Leverage Ratio by using below formula

Leverage Ratio = Total Debt / Total Equity

• Leverage Ratio = $2,00,000 / $3,00,000
• Leverage Ratio = 0.67

Leverage Ratio Formula – Example #2

Let us take an example of company Reliance whose Total Shareholder’s equity is Rs 3,14,632 Cr, long term debt is Rs 81,596 Cr and short term debt is Rs 15,239 Cr. Calculate the Leverage Ratio of a Reliance company.

Solution:

Hence we don’t have Total Debt so first, we will find out the Total Debt

We can calculate the Total Debt by using below formula

Total Debt = Long Term + Short Term

• Total Debt = Rs 81,596 Cr + Rs 15,239 Cr
• Total Debt = Rs 96,835 Cr

Hence now will find out the Leverage Ratio

We can calculate the Leverage Ratio by using below formula

Leverage Ratio = Total Debt / Total Equity

• Leverage Ratio = Rs 96,835 Cr / Rs 3,14,632 Cr
• Leverage Ratio = 0.31

Leverage Ratio Formula – Example #3

Let us take an example of company Tata Steel whose Total Shareholder’s equity is Rs 61,514 Cr, long term debt is Rs 24,568 Cr and short term debt are Rs 670 Cr. Calculate the Leverage Ratio of a Tata Steel company.

Solution:

Hence we don’t have Total Debt so first, we will find out the Total Debt.

We can calculate the Total Debt by using below formula

Total Debt = Long Term + Short Term

• Total Debt = Rs 24,568 Cr + Rs 670 Cr
• Total Debt = Rs 25,238 Cr

Hence now will find out the Leverage Ratio.

We can calculate the Leverage Ratio by using below formula

Leverage Ratio = Total Debt / Total Equity

• Leverage Ratio = Rs 25,238 Cr / Rs 61,514 Cr
• Leverage Ratio = 0.41

Hence the Leverage Ratio is 0.41 

Explanation of Leverage Ratio Formula

Leverage ratio can be defined as the ratio of total debt to total equity of any firm to understand the level of debt being incurred by any firm or entity. Debt is an essential component for any firm as it is significantly cheaper than other forms of money and hence it amplifies profits. On the other hand, a higher leveraged company can face issues if there is a decline in the business of the company. So leverage can reap benefits if used well or create risk for a company if not properly utilized.

There are various kinds of leverage ratios. Some are debt/equity, debt/EBIDTA, debt/assets or debt to total capital. Debt/Equity is a common measure used by investors. There are various ways in which leverage is created for a company: –

1. A company might take debt to purchase assets such as property, plant or equipment.
2. A company borrows debt for its short term requirements such as inventory, liquidity etc.
3. A company might borrow to finance an acquisition of another company.
4. Leveraged Buyout is done by a private equity firm.
5. An individual may borrow to finance his/her purchase of a house.
6. Investors in equity markets may borrow to add stocks to their portfolio.

Increasing leverage has the potential to multiply earnings for an individual or a company. But it also comes with the warning of additional risk. If the cash flows do not support then there is a chance of the company or individual defaulting on their payments. Hence the level of leverage should be defined wisely.

Relevance and Uses of Leverage Ratio Formula

The leverage ratio is an indicator of the inherent risk of a company. When the debt ratio is very high in comparison to its peers, that indicates that the firm is carrying a significant burden since the principal and interest payments would be blocking the company’s cash flows. These cash flows could have been used for an item of capital expenditure or other important ways to grow the company. Also, there are possible circumstances if the cash flows are not large enough to support the debt payments then the company might have to default. Conversely, if the debt level is low in any company, it means that the debt payments do not amount to a large portion of company’s cash flows hence they are not sensitive to an external circumstance such as business changes. But it also indicates the company has the ability to increase its debt level because debt is cheaper than other forms of money. Each company has to find its optimum level of debt that it can support.

But there is no optimum level of debt for any particular company. Leverage ratios should be compared with companies operating in the similar industry. For example, steel companies generally have a higher level of debt than other industries. Hence when looking at a debt level of any steel company, it should only be compared with its peers. If the debt level is higher than its peer companies there may be a cause for concern. Both investors and lenders to any particular firm prefer lower leverage levels since it guarantees that their interests are protected in case of a decline in business of the company or even during default or liquidation. This is one of the reasons why higher leverage ratios may prevent any firm or company to attract additional capital.

Leverage Ratio Formula Calculator

You can use the following Leverage Ratio formula Calculator

Conclusion

The leverage ratio is the ratio of total debt to total equity for any firm or company. Leverage has the benefits of multiplying earnings but it also means the company is taking additional risk and if the cash flows do not support then the company might default on its payments. Any company’s leverage must be compared to the leverage levels of its peers to find out whether the level is higher or lower. It cannot be compared with companies operating in other industries.

Recommended Articles

This has been a guide to Leverage Ratio Formula. Here we discuss How to Calculate Leverage Ratio along with practical examples. We also provide you Leverage Ratio Calculator with downloadable excel template. You may also look at the following articles to learn more –

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