Leverage RatiosExplained and How to Calculate!
You may be asking yourself what a leverage ratio is and simply put, a leverage ratio is any of the many financial measurements that shows just how much of a business’ capital is sourced from debt or loans while also assessing the ability of that business to meet any of its financial obligations.
The leverage ratio category is essential because organizations employ a combination of stock or equity and debt to fund their operations, thus knowing how much debt a company has can help determine whether it will be able to pay off its loans when they are due.
Below we will be discussing what a leverage ratio is, banks and the leverage ratios, leverage ratios for capital and solvency structure evaluation, as well as some of the most prevalent leverage ratios being used today.
What is a leverage ratio?
- A leverage ratio is one of numerous financial metrics used to evaluate a company’s capacity to satisfy its financial obligations.
- A leverage ratio can also be used to estimate how changes in output will affect operating income by measuring a company’s mix of operating expenses.
- The debt-to-equity ratio, degree of financial leverage, equity multiplier, and consumer leverage ratio are all leverage ratios that businesses commonly use.
- The amount of leverage that a bank can have is known to them by the regulatory oversight they possess and is regulated by the government.
What can you learn from a leverage ratio?
A business and those who have invested in it may be put at risk if the business takes on too much debt.
If, in contrast, a company’s operations provide a better rate of return than the interest rate on the loans it has incurred, debt may be used to fuel the expansion of the business.
However, unmanaged debt might result in credit downgrades or worse. On the other end of the spectrum, having too few debts can generate concerns.
A reluctance, refusal or incapacity to borrow could indicate a lack of operating margins.
A leverage ratio can be defined in a variety of ways, but the most important aspects to examine are debt, assets, equity, and interest expenses.
A leverage ratio can also be used to estimate how changes in output will affect operating income by measuring a company’s mix of operating expenses.
The two forms of operating costs to keep in mind are a business’ fixed and variable costs; the mix will vary based on the firm and industry.
Lastly, what we can learn from a leverage ratio through the perspective of the end user is the consumer leverage ratio which is the measure of consumer debt relative to the consumer’s disposable income.
The consumer leverage ratio is a measure that is utilized by economists for the sake of economic analysis and by the government’s policymakers.
The banks and leverage ratio
In the United States, banks are one of the most leveraged or indebted institutions.
The fusion of Federal Deposit Insurance Corporation (FDIC) protection with fractional reserve banking has resulted in a banking environment with low lending risks.
Three distinct regulatory agencies that are the Federal Deposit Insurance Corporation, the Comptroller of the Currency and the Federal Reserve indemnify and make up for the fact that banks are the most indebted institutions by examining and limiting the leverage ratios of the banks in America.
What this means is that those three distinct regulatory agencies restrict the amount a bank can lend depending on the amount of capital the bank dedicates to the assets it owns.
The amount of capital a bank has is crucial as banks have the ability to write down the part of their assets that came from their capital in the event that the total value of the assets drop.
Despite this, the assets that a bank owns due to debt financing cannot be part of the capital that gets written down as those who hold the bonds of the bank and those who have deposited into the bank are owed the amount spent to acquire those assets.
Regulations that banks follow when it comes to leverage ratios can be quite complex.
Guidelines have been created by the Federal Reserve that put varying restrictions on bank holding companies based on the rating assigned to the respective bank.
Generally speaking, banks that undergo financial or operational difficulties in addition to banks that are growing rapidly must sustain leverage ratios that are higher than banks who do not experience the same scenarios.
Numerous forms of capital requirements and minimum reserves exist which are implemented on banks in America by the Comptroller of the Currency and the Federal Deposit Insurance Corporation.
These forms of capital requirements and minimum reserves are what impacts a bank’s leverage ratios indirectly.
The amount of auditing, inspection and examination each bank has to undergo have significantly increased since 2007 to 2009 when the Great Recession happened and banks that were considered as “too big to fail” ended up becoming a calling card to have banks possess more assets than liabilities to ensure that almost every debt incurred can be paid for.
The restrictions that were implemented limited the loans a bank could grant as these restrictions made it more challenging and more expensive to raise the capital needed than when an entity just opts to borrow money.
If additional shares have been issued, share value gets diluted and dividends are reduced when there is a higher capital requirement.
The leverage ratio of tier 1 is what is usually used by regulating agencies for banks.
Leverage Ratios for Capital and Solvency Structure Evaluation
There are several leverage ratios that can be used to evaluate the capital and solvency ratios of an entity.
It is highly possible that the most commonly known financial leverage ratio is a business’ debt to equity ratio.
The Debt to Equity Ratio (D/E)
The debt to equity ratio of any entity is computed as follows:
Debt to Equity Ratio = Total Shareholder’s Equity/Total Liabilities
An example of how the debt to equity ratio is used in a situational basis using figures for demonstration purposes only, is when the long term debt for the quarter ending in December 2020 was $21.8 billion under the United Parcel Service.
The total equity of United Parcel Service’s stockholders for the year ending in December 2020 was $3.3 billion.
Using the formula given, it is found that the debt to equity ratio of United Parcel Service for the ending quarter is 8.62 which is an amount that is considered as a high ratio in the industry.
A debt to equity ratio that is high will typically suggest that the business has been aggressive in funding its expansion and growth through the use of borrowed funds.
When this happens, additional expenses on interest will produce earnings that are volatile.
The chances of a business having to default or file for bankruptcy increases if its interest expense goes unmanaged.
Depending on which industry, different bars for the amounts considered as “high” or as “low” for a debt to equity ratio will be established though usually, an investor considers a business as a risky investment when its debt to equity ratio is greater than 2.0.
There are businesses that need larger capital expenditures (CapEx) such as those in the manufacturing and utility industries which would need to have more loans secured compared to other kinds of companies.
It is advisable to compare and evaluate a business’ leverage ratios against other companies within the same industry and its own past performance to have a better understanding of the gathered data as a whole.
In the example given, United Parcel Service has a debt to equity ratio of 8.62 while its competitor that operates in the same courier industry – named FedEx – has a debt to equity ratio of 1.78 which could be a concern for United Parcel Service if most analysts did not determine that the company can generate enough revenue to cover the debts it incurs.
The Equity Multiplier
A leverage ratio similar to the debt to equity ratio is known as the equity multiplier though it differs in computation where the numerator is the business’ assets instead of its debts.
Equity Multiplier = Total Assets/Total Equity
To understand what the equity multiplier can tell us, let us suppose that Macy’s (NYSE: M) owns assets that are worth $19.85 billion with a stockholder equity valued at $4.332 billion.
In this case, the equity multiplier would be computed as follows:
$19.85 billion ÷ $4.332 billion = 4.58
In this formula, debt is not referenced specifically though it is understood that the value of the total assets the company has would include factors such as assets owned through borrowed money.
Bear in mind that a company’s total assets are composed of the company’s total shareholder’s equity added to its total debt.
Through computing for Macy’s equity multiplier of 4.58 we find that the company has a high ratio so its assets are mostly funded from loans than the equity of the company.
From this calculation to derive Macy’s equity multiplier we see that the company’s assets are funded by liabilities worth $15.53 billion.
In calculating the return on equity (ROE), the equity multiplier is an element in the DuPont analysis and can be found in its formula as follows:
DuPont analysis = (NPM) (AT) (EM)
Where NPM is the net profit margin, AT is the asset turnover and lastly, EM is the equity multiplier.
The Debt to Capitalization Ratio
To find out the firm’s ability to utilize obligations through acquisition of assets in order to generate bigger earnings than their borrowing costs, we start by computing their debt to capitalization ratio.
This is a metric measure that showcases the firm’s fraction of total liabilities to their total equity composition and it is computed by dividing total debts, which includes short term and long term obligations, over total shareholder’s equity, which is composed of the total debts and capital.
The formula for computing a business’ total debt to capitalization ratio is as follows:
Total Debt to Capitalization Ratio = Total Liabilities/Total Shareholder’s Equity
This method comprises of a firm’s non-controlling interest, preferred shares, and common shares for its capital.
And instead of treating it as an outright expense, operating leases are treated as amortizable investments.
Similarly, an expert would rather use both short term and long term liabilities instead of only long term ones to get the result for this ratio because both obligations are part of the company’s equity composition.
The Degree of Financial Leverage
A financial ratio that estimates a firm’s responsiveness to fluctuations by dividing the percentage change in their earnings per share (EPS) to their percentage change in earnings before interests and taxes (EBIT) is the degree of a firm’s financial leverage (DFL).
This ratio evaluates the firm’s vulnerability to certain shifts in their operating income due to a change in their equity composition.
Degree of Financial Leverage (DFL) = $Change in EPS/%Change in EBIT
Another way to compute for a business’ degree of financial leverage is shown through the alternative formula below:
Degree of Financial Leverage (DFL) = EBIT/EBIT – Interest Expense
Typically, interest expense is fixed and if your operating earnings are increasing this denotes that your trading on equity increases your returns and your earnings per share as well but if it does not, that is where the problem comes in which would show your ratio has a high degree of financial leverage indicating that your income is quite unstable.
The Consumer Leverage Ratio
We can see how much a regular American spends his discretionary earnings on his/her obligations by computing their consumer leverage ratio.
In the past few years, one determinant of a business’ growth is the increase of a consumer’s liabilities which a number of experts have claimed to be the case while some disagreed and instead foretold that it was a major source for the great depression.
To compute the consumer leverage ratio, we make use of the following formula:
Consumer Leverage Ratio = Total Household Debt/Personal Disposable Income
Acquiring debts is a part of life and running a business which we cannot completely do away with in every situation. It should be noted that how and why you acquire any debt will ultimately influence how it will affect you. A beneficial way to acquire debt is for business purposes that could yield desirable income. To ensure this would happen, we have to be able to recognize that debt can increase your overall revenue as it can increase earnings and yet it can also produce a great loss unless you understand leveraging and how to make it work for and with you.
The Debt to Capital Ratio
A way to assess a firm’s ability to utilize its debts to acquire more assets that is expected to generate a bigger income compared to their cost of borrowing it, is to compute for their debt to capital ratio.
A debt to capital ratio is a critical debt ratio which compares the proportion of your liabilities, combining your short term and long term obligations, to your capital which tallies together your total debts and equity.
Usually, a high debt to capital ratio denotes that a firm is heavily reliant on borrowing money to fund their daily operations.
As a result, firms with high debt-to-capital ratio are at risk for solvency issues. The normal range for your debt to capital ratio depends on the industry you are in, just like how the oil business should maintain 40% of its boundaries.
Anything beyond that limit could significantly affect your expenses used to acquire obligations.
The Debt to EBITDA Leverage Ratio
Normally needed by most credit institutions, debt to EBITDA leverage ratio shows the level that a firm is likely to fail when it comes to paying their liabilities.
In other words, it gives these institutions the information needed to determine a certain business’s capability to meet their obligations.
Under the point of view of business owners, this ratio tells them how much earnings before interest, taxes, depreciation and amortization (EBITDA) it will take to fulfill their debts.
The performance of your debt to EBITDA leverage ratio varies in the industry you are in.
Since the oil and gas business mostly have debts to pay, their ratio should not be more than 3 in a typical scenario for example.
The Debt to EBITDAX Ratio
Very popular in the United States, debt to EBITDAX ratio is a technique used to standardize various accounting methods – the full cost formula and the successful efforts formula – for exploration expenditures.
Despite how similar it is to the debt to EBITDA leverage ratio, they are actually two distinct ratios with their only difference being that EBITDAX is EBITDA excluding exploration costs.
Examples of exploration expenses are costs of duster, cost of abandonment, and costs to acquire rights to explore. Asset impairment, accretion expense for an asset retirement obligation (ARO), and deferred taxes are some non-cash payment accounting expenses that should be included to compute for your total exploration costs.
The Interest Coverage Ratio
To determine a firm’s capability to utilize their debts, which is the common problem when you only study the firm’s entire obligations, is to compute for their interest coverage ratio, which primarily focuses on a firm’s ability to fulfill its interest payments.
Usually, the preferable ratio is 3.0 exactly or more than 3.0 but that depends on the industry you operate in. And in order to obtain your coverage ratio, all you have to do is divide your operating income by your interest expense.
The Fixed Charge Coverage Ratio
A distinct version of the interest coverage ratio which emphasizes on a firm’s cash flow performance that can fulfill interest obligations regarding long term debts is the fixed charge coverage ratio also known as times interest earned (TIE).
As usual, the higher the amount of the ratio, the more ideal the result is.
It is important to use earnings before interest and taxes (EBIT) when computing for this particular ratio because interests can be applied to reduce your taxes. Once you have obtained your EBIT, divide it by your interest expense of long term obligations to get your fixed charge coverage ratio.