Leverage ratios are a tool to measure the risk and health of a business. They are used by accountants, analysts, investors, lenders, and finance managers to measure how a business is using leverage—fixed costs used to create revenue—in its operations, and how well it can meet financial obligations. Leverage ratios are also used by regulators to measure the financial strength of banks, along with how well they can weather poor markets and economic conditions.
We'll look at the different leverage ratios and how investors, finance managers, and regulators use each.
Definition and Examples of Leverage Ratios
Leverage is how a business uses fixed costs to earn revenue. Fixed costs remain the same for a business regardless of sales and revenue. Financial leverage is how a business uses debt to grow profits by borrowing money to purchase assets. If the investment return is higher than the cost of borrowing, shareholders benefit with higher profits. Financial leverage works the other way as well: If the investment return is lower than the cost of borrowing, shareholders suffer losses.
Operating leverage is how fixed operating costs for things like facilities and equipment are used to generate revenue, usually expressed as a percentage of total costs.
A business with high operating leverage has high fixed costs, as seen in a manufacturing business. It is more sensitive to changes in sales than a business with low operating leverage.
Leverage ratios measure the financial and operating leverage in a business. Financial leverage ratios compare the debt of a business to other financial criteria. Debt includes bonds payable, leases, lines of credit, and loans payable. Not all liabilities—for example, accounts or dividends payable—are considered debt.
One of the most common financial leverage ratios is debt to equity. It shows investors how much debt is used to finance the business’s operations. A higher ratio tends to indicate a greater level of risk to investors in the event of a bankruptcy or liquidation, because bondholders and creditors get paid before shareholders.
In the example balance sheet below:
Total debt = short-term notes + long-term debt = $296,500
Shareholders’ equity = capital stock + retained earnings = $413,000
Debt to equity = $296,500/$413,000 = 0.72
|Property, Plant, Equipment||$420,000|
Types of Leverage Ratios
|Debt to Equity||Total Debt/Equity|
|Debt to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)||Total Debt/EBITDA|
|Asset to Equity||Total Assets/Total Equity|
|Degree of Operating Leverage (DOL)||Sales - Variable Cost/Profit|
|Debt to Asset||Total Debt/Total Assets|
Debt to Equity
Measures the amount of debt used to finance business operations versus the amount of stockholders’ equity. Bankers and investors use debt to equity to evaluate the risk of a loan.
Debt to Earnings Before Interest, Taxes, Depreciation, and Amortization
Used to measure the ability to make interest and principal payments. A higher debt-to-earnings ratio means more revenue is used to service debt, and represents a higher risk to investors.
Degree of Operating Leverage
Measures a business's operating risk. A business with a high DOL needs to maintain a high level of sales to cover all fixed costs and make a profit. A greater DOL also means that a business may have difficulty adjusting during a downturn, which represents a higher risk to investors.
Debt to Asset
Measures the capacity of a business to borrow funds.
Asset to Equity
Measures how much of the business is owned by investors or a bank. A low asset to equity ratio means the business skews toward taking on more debt to purchase assets.
A higher debt-to-equity ratio poses a higher risk to shareholders in the event of financial difficulties or bankruptcy because creditors get paid first.
How Leverage Ratios Work
The leverage ratios of a business are measured against similar business and industry peers. In our example above, the company has a debt-to-equity ratio of 0.72. If the balance sheet was for an advertising agency, its industry average for debt to equity is 0.81, so the ratio shown would be in line with that.
If our sample balance sheet is, however, a home furnishings business, the industry average for debt-to-equity ratio is 0.47, so the ratio here would be considered high. A high ratio isn't necessarily bad, but a potential investor would want to know why it's out of line with peers.
The leverage ratio for banks compares so-called Tier 1 capital to the total assets of the bank. Tier 1 capital is the value of capital stock + retained earnings. Total assets of the bank include reserves, securities, and loans.
Generally, banks are required by the Federal Reserve to maintain a 5% leverage ratio. Banks with less than $10 billion in assets that can qualify as a community bank have to maintain a leverage ratio of 9%. The 19 largest banks have higher leverage ratio requirements, and they have to include certain off-balance-sheet assets such as unused credit commitments and letters of credit.
A business with a high degree-of-operating-leverage ratio has to maintain a higher level of sales to cover its fixed costs, such as plant and equipment.
If sales decrease, the fixed costs still need to be paid. Sales increases over the amount that covers the fixed cost of the business have a high impact on income. A business with a low degree of operating leverage has low fixed expenses. Increases or decreases in sales don't have as much impact on its income. The business in this case does not have to contend with high fixed costs, and can adjust to economic and market conditions.
What It Means for Individual Investors
Individual investors can use leverage ratios to understand how a business is performing relative to its peers. The ratios can be used to gain insight into the risk and potential return of making an investment in a business or its stock.
Changes in average leverage ratios across industries also can give investors a high-level view of the health of the economy and help them make portfolio decisions.
- Financial leverage is how a business uses debt to grow its revenue.
- Operating leverage is the way fixed operating costs such as facilities and equipment are used to generate and increase revenue.
- Leverage ratios measure the financial health and profit potential of a business.
- Leverage ratios are used by investors and lenders to evaluate the risk of a business.
- Leverage ratios are also employed by regulators to monitor and control the financial strength of banks.