Leverage ratios are a collection of formulas commonly used to compare how much debt, or leverage, a company has relative to its assets and equity. It shows whether a company is using more equity or more debt to finance its operations. Understanding a company’s debt situation is a key part of fundamental analysis during stock research. Calculating its financial leverage ratio helps potential investors understand a company’s ability to pay off its debt.
A high leverage ratio could indicate that a company has taken on more debt than it can pay off with its current cash flows, potentially making the company a riskier investment.
How to Calculate Leverage
A company increases its leverage by taking on more debt, acquiring an asset through a lease, buying back its own stock using borrowed funds, or by acquiring another company using borrowed funds.
There are several types of leverage ratios, which compare a company’s or an individual’s debt levels to other financial indicators. Some commonly used ones are:
Debt-to-Assets Ratio
This ratio compares a company’s debt to its assets. It is calculated by dividing total debt by total assets. A higher ratio could indicate that the company has purchased the majority of its assets with debt. That could be a warning sign that the company doesn’t have enough cash or profits to pay off these debts.
Formula: Total debt / total assets
Debt-to-Equity Ratio (D/E)
The debt-to-equity ratio compares a company’s debt to its equity. It is calculated by dividing total debt by total equity. If this ratio is high, it could indicate that the company has been financing its growth using debt.
The appropriate D/E ratio will vary by company. Some industries require more capital and some companies may need to take on more debt. Comparing ratios of companies in the same industry can give you a sense of what the typical ranges are.
Formula: Total debt / total equity
Asset-to-Equity Ratio
This is similar to the D/E ratio, but uses assets instead of debt. Assets include debt, so debt is still included in the overall ratio. If this ratio is high, it means the company is funding its operations mostly with assets and debt rather than equity.
Formula: Total assets / total equity
Debt-to-Capital Ratio
Another popular ratio, this one looks at a company’s debt liabilities and its total capital. It includes both short- and long-term debt, as well as shareholder equity. If this ratio is high, this may be a sign that the company is a risky investment.
Formula: Debt-to-capital ratio: Total debt / (total debt + total shareholder equity)
Degree of Financial Leverage
This calculation shows how a company’s operating income or earnings before interest (EBIT) and taxes will impact its earnings per share (EPS). If a company takes on more debt, it may have less stable earnings. This can be a good thing if the debt helps the company earn more money, but if the company goes through a less profitable period it could have a harder time paying off the debt.
Formula: % change in earnings per share / % change in earnings before interest and taxes
Consumer Leverage Ratio
This ratio compares the average American consumer’s debt to their disposable income. If consumers go into more debt, their spending can help fuel the economy, but it can also lead to larger economic problems.
Formula: Total household debt / disposable personal income
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Ways to Use Leverage Ratio Calculations
Understanding the definition of leverage ratio and the formulas for various types, is the first step toward using the measurement to make investing decisions. Investors use leverage ratios as a tool to measure the risk of investing in a company.
Simply put, they show how much borrowed money a company is using. Each industry is different, and the amount of debt a company has may differ depending on who its competitors are and other factors, such as its historical profits. In a very competitive industry or one that requires significant capital investment, it may be riskier to invest in or lend to a company with a high leverage ratio.
The interest rates companies are paying matters also, since debt at a lower rate has a smaller impact on the bottom line.
Regardless of industry, If a company can not pay back its debts, it may end up going bankrupt, and the investor could lose their money. On the other hand, if a company is using some leverage to fuel growth, this can be a good sign for investors. This means shareholders can see a greater return on equity when the company profits off of that growth. If a company can’t or chooses not to borrow any money, that could signal that they have tight margins, which may also be a warning sign for investors.
Investors can also use leverage ratios to understand how a potential change in expenses or income might affect the company.
Recommended: How Interest Rates Impact the Stock Market
How Lenders Use Leverage Ratios
In addition to investors, potential lenders calculate leverage ratios to figure out how much they are willing to lend to a company. These calculations are completed in addition to other calculations to provide a comprehensive picture of the company’s financial situation.
Overall, leverage ratio is one calculation amongst many that are used to evaluate a company for potential investment or lending.
Recommended: What EBIT and EBITDA Tell You About a Company
How Leverage is Created
There are several different ways companies or individuals create leverage These include:
• A company may borrow money to fund the acquisition of another business by issuing bonds
• Large companies can take out “cash flow loans” based on their credit status
• A company may purchase assets such as equipment or property using “asset-backed lending”
• A company or private equity firm may do a leveraged buyout
• Individuals take out a mortgage to purchase a house
• Individual investors who trade options, futures, and margins may use leverage to increase their position
• Investors may borrow money against their investment portfolio
The Takeaway
All leverage ratios are a measure of a company’s risk. Understanding basic formulas for fundamental analysis is an important strategy when starting to invest in stocks. Such formulas can help investors weigh the risks of a particular asset investment and compare assets to one another.
There are numerous ways to use leverage ratios, and lenders can use them as well. In all, knowing the basics about them can help broaden your knowledge and understanding of the financial industry.
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