What is Leverage Ratio?
Leverage Ratio is a ratio that focuses on the solvency of a company keeping the capital raised from Debt structuring or from the company itself to meet the company’s financial obligations. It can also be said that the Leverages measures the long-term stability & capital structure of the firm. The leverage ratio helps the management identify how much they are capable to borrow in order to increase the profitability of the company. Leverages help to find the debt raising capacity of the company according to their present capital structure.
Types & Formula to Leverage Ratio
There are many ratios to be calculated under Leverage Ratios. Following are the types and their respective formulas to calculate different leverage ratios:
1. Debt-Equity Ratio
This ratio represents the ratio of Debt over the Equity of the Company
Total Equity = Equity Share Capital + Reserves & Surplus
2. Debt to Asset Ratio
This ratio represents the ratio of Debt of the company compared with the assets of the company.
3. Debt to Capital
This ratio represents the ratio of Debt in the total Capital of the company.
Total Capital = Total Equity + Total Debt
4. Debt to EBITDA
This ratio explains the ratio of Debt to the Earnings of the company.
EBITDA = Earnings before Interest Tax Depreciation & Amortization.
5. Asset to Equity Ratio
This ratio helps to understand the value of the assets compared with the shareholder’s capital.
Examples of Leverage Ratio (With Excel Template)
Let’s take an example to understand the calculation in a better manner.
Following is the balance sheet of XYZ Inc. for the year ended as on 31 Dec. 20XX. You are required to calculate the Leverages.
Total Shareholder’s Fund is calculated using the formula given below
Total Shareholder’s Fund = Shareholders’ Funds + Reserves & Surplus
- Total Shareholder’s Fund = 500,000,000 + 100,000,000
- Total Shareholder’s Fund = 600,000,000
Total Debt is calculated using the formula given below
Total Debt = Long Term Loans + 9% Debentures
- Total Debt = 150,000,000 + 250,000,000
- Total Debt = 400,000,000
Total Capital is calculated using the formula given below
Total Capital = Total Debt + Total Shareholders’ Funds
- Total Capital = 600,000,000 + 400,000,000
- Total Capital = 1,000,000,000
Debt-Equity Ratio is calculated using the formula given below
Debt-Equity Ratio = Total Debt / Total Equity
- Debt-Equity Ratio = 400,000,000 / 500,000,000
- Debt-Equity Ratio = 0.80
Debt-Assets Ratio is calculated using the formula given below
Debt-Assets Ratio = Total Debt / Total Assets
- Debt-Assets Ratio = 400,000,000 / 1,500,000,000
- Debt-Assets Ratio = 0.27
Debt-Capital Ratio is calculated using the formula given below
Debt-Capital Ratio = Total Debt / Total Capital
- Debt-Capital Ratio = 400,000,000 / 1,000,000,000
- Debt-Capital Ratio = 0.40
Debt-EBITDA Ratio is calculated using the formula given below
Debt-EBITDA Ratio = Total Debt / EBITDA
- Debt-EBITDA Ratio = 400,000,000/105,000,000
- Debt-EBITDA Ratio = 3.81
Assets-Equity Ratio is calculated using the formula given below
Assets-Equity Ratio = Total Assets / Total Equity
- Assets-Equity Ratio = 1,500,000,000 / 600,000,000
- Assets-Equity Ratio = 2.50
Uses & Importance of Leverage Ratio
Leverage ratios are important as they provide a view to the management about the company’s leverage position as to how the company is leveraged and how much debt the company is in. The debt is often termed as load on the company’s balance sheet and the management time to time wants to keep a check on the rising debt of the company. Let us say, that a company is having a higher debt ratio, that means the company would have a bigger burden of clearing the debt in principal as well as interest payment which will affect adversely the company’s cash flow. Whereas compared to a low debt ratio, both the principal and interest ratio would not have that much impact on the cash flow of the company. Also with the low impact on the cash flow, the low debt ratio also indicates that the company has unutilized leverages which can be used to make company more profitable and grow its business. High leverage shows that the company should repay their debts so as to release their cashflows from the burden of interest & principal payment. Analysis of Leverage Ratios are important for both internal & external parties involved in the business, be it is investor, creditors or management. These ratios are important as they provide a detailed view of the financial health of the company and its capability to meet its financial liabilities. The creditors can rely on these ratios up to an extent of credit provided to the company even if the company is highly under debt but have good and healthy earnings and good return on their Investments which can easily meet their interest liability.
Advantages and Disadvantages
Below are the advantages and disadvantages:
Let us first discuss the benefits of the Leverage Ratios:
- A leverage ratio can operate fully independently of any complex modeling assumptions;
- Leverage Ratios are a complementary instrument to risk-weighted requirements when assessing with banks’ capital adequacy.
- Leverage Ratios ensure minimum buffer to absorb the negative consequences of imprudent behavior.
- Leverage Ratios help Banks a lot in identifying the financial health of the companies before providing them the financial aids.
- It provides a clear picture of the company’s finances and earning for shareholders’ capacity which is very helpful for all the relevant insiders and outsiders of the company.
- Off-Balance Sheet Exposures: To get the leverage ratios, the capital has to be divided by total assets of the company. Therefore it fails to take into account the items which are not included in the balance sheet. To include these items which are not in the balance sheet the banks will need to built-up a large off-balance sheet exposures to take into account these items.
- Pro-cyclicality: The concern regarding the leverage ratios will amplify the financial cycle are valid. This is due to firstly, because of imposition of the leverage ratio in the present crises will additionally put deleveraging pressure on the banks and secondly, these crises will make the availability of credit facility more volatile in the longer run.
Leverage ratios are important indicators of the financial health of the company. They are used to measure the solvency of the company, their financial structure and helps in taking important decisions relating to the fundraising for their future plans and growth of the company.
This is a guide to the Leverage Ratio. Here we discuss how to calculate along with practical examples. We also provide a downloadable excel template. You may also look at the following articles to learn more –