Leverage Ratio: Definition, Types

Definition

A leverage ratio is a financial metric that evaluates the amount of capital that comes from debt (loans) or evaluates a company's capacity to satisfy its financial obligations. A leverage ratio shows how much debt an organization has taken on in relation to other accounts on its balance sheet, income statement, or cash flow statement.

How does a leverage ratio work?

Companies employ a combination of equity and debt to fund their operations, therefore the leverage ratio is important. By understanding how much debt a firm has, one can assess its ability to pay off its loans when they become due.

For a business and its investors, having excessive debt can be disastrous. Debt may, however, contribute to growth if a company's operations can bring in a higher return on investment than its loan's interests.

A company that uses debt to finance its operations will have a higher financial leverage ratio, which is frequently a red flag for potential investors that the company might not be a safe investment. It could imply irregular earnings, a long wait before shareholders see a significant return on their investment, or even the imminent insolvency of the company.

These measures are also used by creditors to decide whether to grant credit to firms. A corporation is more likely to default on loans if its financial leverage ratio is too high because most of its cash flow is going toward debt repayment.

A company with a stable income stream and a lower financial leverage ratio is typically considered to be more financially prudent. An extraordinary financial leverage ratio signals to potential investors and credit agencies that a business poses little danger and is probably worth investing in, even if the corporation behind it is carrying large debts.

In order to estimate how variations in output would impact operating income, a company's operating expenses may also be measured using a leverage ratio. The two forms of operating costs are fixed costs and variable costs; the evaluation may vary depending on the business and the industry.

Depending on the type of ratio in view, different levels of financial leverage are acceptable. Higher numbers are actually preferable for some ratios, like the interest coverage ratio. However, smaller ratios typically represent organizations that are functioning well.

A regular startup frequently needs to take on sizable debts to begin going, and it must set aside a sizeable amount of its cash flow to pay them off. This leads to increased financial leverage ratios. Larger production expenses are also associated with higher debt-to-equity ratios than are typical for other businesses.

Additionally, some businesses naturally support greater average financial leverage ratios. In those circumstances, comparing a company's financial leverage to that of its rivals will allow you to determine how healthy it is.

Types of Leverage Ratio

Leverage ratios can refer to a number of various ratios, but the key ones taken into account are debt, equity, assets, and interest costs.

Market analysts, investors, or creditors may take into account a variety of distinct leverage ratios. Total assets, total equity, operating expenses, and incomes are a few accounts that are thought to be significantly comparable to debt.

Below are the five most common leverage ratios

·        Debt-to-Assets Ratio = Total Debt / Total Assets

·        Debt-to-Equity Ratio = Total Debt / Total Equity

·        Debt-to-Capital Ratio = Today Debt / (Total Debt + Total Equity)

·        Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)

·        Asset-to-Equity Ratio = Total Assets / Total Equity