What Is a Leverage Ratio?

A leverage ratio is a type of financial measurement used in finance, business, and economics to evaluate the level of debt relative to another financial metric. It can be used to measure the amount of capital in the form of debt and loans, or to assess a company's ability to meet its financial obligations.

Leverage ratios are important in business, finance, and economics because companies and institutions rely on a mixture of equity and debt to finance their operations. Knowing the amount of debt held is useful in evaluating whether it can be paid off as it comes due.

How Does a Leverage Ratio Work?

Lever♛age ratios assess the ability of a company, institution, or indiv𒈔idual to meet their financial obligations. Carrying too much debt can be dangerous for a company and its investors, but the debt may help fuel growth if a company’s operations can generate a higher rate of return than the interest rate on its loans.

Uncontrolled debt levels can lead to credit downgrades or even worse consequences. However, too few debts can also raise questions. A reluctance or inability to borrow may indicate that operating margins are tight.

A leverage ratio might also be used to measure a company’s mix of operating expenses to get an idea of how changes in output wiꦫll 🧸affect operating income. Operating costs can be fixed or variable. The mix will differ depending on the company and the industry.

Banks and Leverage Ratios

Banks are among the most leveraged institutions in the United States. The combination of fractional-reserve banking and 澳洲幸运5官方开奖结果体彩网:Federal Deposit 𒈔Insurance Corp. (🗹FDIC) protection has produced a banking environment with limited lending risks. The FDIC, the Federal Reserve, and the Office of the Comptroller of the Currency (OCC) review and restrict the leverage ratios for American banks.

These bodies 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 can't be written down because the bank's bondholders and depositors are owed these funds.

The Federal Reserve created guidelines for bank holding companies, but these restrictions vary depending on the rating assigned to the bank. Banks that experience rapid growth or face operational or financial difficulties are generally required to maintain higher 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 pressures haven’t gone away. Restrictions keep getting tighter.

Regulators proposed that banks with $100 billion or more in assets dramatically add to their capital cushions in 2023 following the collapse of several lenders. These restrictions limit the number of loans made because it's 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 shares are issued.

Types of Leverage Ratios

There are many different types of lever🥂age ratios—here are a few.

Debt-to-equity (D/E) Ratio

Equity Multiplier

The eಌquity multiplier is similar, but it replaces debt with assets in the numeratꦕor:

$\text{Equity Multiplier} = \frac{\text{Total Assets}}{\text{Total Equity}}$Equity Multiplier=Total EquityTotal Assets​

Assume that Macy's ha🐭s assets valued at $19.85 billion and 💎stockholder equity of $4.32 billion. The equity multiplier would be:

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

Debt isn't specifically referenced in the formula, but it🤡's an underlying factor given that total assets include debt. The company's high ratio of 4.59 ind꧒icates that assets are mostly funded with debt rather than equity. 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):

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

It's generally better to have a low equity multiplier because this means that a company isn't incurring excꦬessive debt to finance its assets.

Debt-to-capitalization Ratio

The debt-to-capitalization ratio measures the amount of debt in a company's capital strไucture. It's calculated as:

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

Operating leases are capitalized, and equity includes both common and preferred shares. An analyst might decide to use total debt to measure the debt used in a firm's capital structure instead o🅰f using long-term debt. This formula would include minority interest and preferred shares in the denominator.

Degree of Financial Leverage 

Degree of financial leverage (DFL) is a ratio that measures the sensitivity of a company’s ea💮rnings 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 calculated using the formula:

$\begin{aligned} &DFL = \frac{\% \text{ change in }EPS}{\% \text{ change in }EBIT} \\ &\textbf{where:}\\ &EPS=\text{earnings per share}\\ &EBIT=\text{earnings before interest and taxes}\\ \end{aligned}$​DFL=% change in EBIT% change in EPS​where:EPS=earnings per shareEBIT=ear🦂nings before i🥀nterest and taxes​

DFL can alternatively be represented by the equation below💮:

$DFL = \frac{EBIT}{EBIT - \text{interest}}$DFL=EBIT−interestEBIT​

This ratio indicates that the higher the degree of financial le✅verage, the more volatile earnings will be. Interest is usually a fixed expense, so 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.

Consumer Leverage Ratio

🌊The consumer leverage ratio is used to quantify the amount of debt the average American consumer has relative to their disposable income. Some economists have stated that the rapid increase in consumer debt levels has been a contributing factor to corporate earnings growth. Others blamed the high level of consumer debt as a major cause of the Great Recession.

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

Debt-to-capital Ratio

The 澳洲幸运5官方开奖结果体彩网:debt-to-capital ratio&nb🍷sp;focuses on the relationship of debt liabilities as a component of a company's total capital base. It's calculated by dividing a company's total debt by its total capital, which is the sum of to🥂tal debt and total shareholders' equity. Debt includes all short-term and long-term obligations.

This ratio is used to evaluate a firm's financial structure and how it finances its operations. The higher the debt-to-capital ratio, the higher the risk of default is. Earnings may not be enough to cover the cost of debts and liabilities if the ratio is very high. A reasonable debt-to-capital ratio depends on the industry. Some sectors use more leverage than others.

Debt-to-EBITDA Leverage Ratio

The 澳洲幸运5官方开奖结果体彩网:debt-to-EBITDA leverage ratio measures the amount of income generated and available ౠto pay down debt before a company accounts for interest, taxes, depreciation, and amortization expenses. This ratio is commonly used by credit agencies. It's calculated by dividing short- and long-term debt by EBITDA. It determines the probability of defaulting on issued debt.

This ratio is useful in determining how many years of earnings be🌸fore interest, taxes, depreciation, and amortization (EBITDA) would be required to pay back all the debt. It can be alarmi🌄ng if the ratio is over 3.0, but this can vary by industry.

Debt-to-EBITDAX Ratio

The debt-to-EBITDAX ratio is similar to the debt-to-EBITDA ratio. It measures debt against EBITDAX rather than EBITDA.

EBITDAX stands for "earnings before interest, taxes, depreciation (or depletion), amortization, and exploration expense." It expands EBITDA by excluding exploration costs, a common expense for oil and gas companies.

This ratio is commonly used in the United States to normalize various accounting treatments for exploration expenses: The full cost me🅷thod vs. the successful efforts method. Exploration costs are typically found in financial statements as exploration, abandonment, and dry hole costs. Other non-cash expenses that should be added back are impairments, accretion of asset retirement obligations, and deferred tax🎉es.

Interest Coverage Ratio

The 澳洲幸运5官方开奖结果体彩网:interest coverage ratio is also concerned with interest payments. One problem with 👍only reviewing a company's total debt liabilities is that it doesn't reveal anything about its ability to service the debt. The interest coverage ratio aims to fix this.

This ratio equals operating income divided by interest expenses. It showcases the company's ability to make interest payments. A ratio of 3.0 or higher is generally desirable, but it varies by industry.

Fixed-Charge Coverage Ratio

Times interest earned (TIE) is also known as a 澳洲幸运5官方开奖结果体彩网:fixed-charge coverage ratio. It's a variation of the interest coverage ratio. It attempts to highlight cash flow relative to interest owed on long-term🌠 liabilities.

Find the company's earnings before interest and taxes (EBIT), then divide this by the interest expense of long-term debts. Use pretax earnings because interest is tax-deductible. The full amount of earnings can eventually be used to pay interest. Higher numbers are more favorable.

The Bottom Line

Leverage ratios are useful tools. They provide a simple way to evaluate the extent to which a company or institution relies on debt to fund and expand its operations. Debt can generate a higher rate of return than it costs when it's used effectively, but too much is dangerous and can lead to default and financial loss. Leverage ratios are most useful to look at in comparison to past data or a comparable peer group.