A leverage ratio is a financial tool that assesses the relative level of debt load, which the business has incurred. The ratios compare the total debt obligation to either the equity or the business’s assets. If the figure is high, it shows the business has incurred a high debt than expected to service with its current assets. It also shows how much of the resources of the company belong to shareholders as opposed to creditors. When the shareholders have a majority stake in the assets, then the leverage is low. When the creditors have a larger stake, the company has high leverage. Some of the most common leverage ratios include the following:

  • Equity Ratio: The equity ratio measures the assets financed by the investments by comparing the total equity to total assets. This tool highlights two significant concepts of a solvent company. The first element illustrates how much of the assets are possessed by stakeholders. The second element illustrates how much of the business’s assets were financed by debt.
  • Debt capital ratio: the ratio assesses the financial leverage by comparing the total liabilities to the total capital. The debt to capital evaluates the ratio of debt which a company uses for funding the ongoing activities. The metric may also help one understand a range of things about the business, such as capital structure and solvency.
  • Debt to assets: this is a leverage ratio that shows the portion of assets financed with debt. Creditors also use the ratio to evaluate the debt present in a business, its ability to repay the debt, and if additional loans would be extended. Investors may also use it to ensure the firm is in good financial health to meet its obligations.

How Leverage ratios are Used

These are great ways to assess risk whether a business can pay back its debts. A moderate level of leverage would be advantageous to the shareholders because it illustrates a company is minimizing the utilization of equity for funding operations that increases the return on equity for the current shareholders. At the same time, significantly high debt loads may be acceptable within monopoly or duopoly situations considering the cash flows required to service the debt would be consistent over a period.

A creditor would use the leverage ratios as part of their evaluations on whether it would be in their best interests to lend money to the business. These ratios do not necessarily give enough information for lending decisions, though. The lender should know if the business is creating sufficient cash flows to pay the debt. That would mean reviewing the budget to assess if the cash flows would support the ongoing payments.

The nature of the industry the company is in would play a role in lending as well. If the industry does not have a lot of competition, for example, it means there are high barriers to entry. That would be combined with a long history of large profits so an organization could maintain high debt over time. On the other hand, in an industry where market share would change continually, and the capital investment requirements are high, the creditors would not want to lend money. Leverage ratios are there for a part of the analysis when assessing an organization’s potential; however, a lot of information is needed before a decision to lend would be made.

Importance of Leverage Ratios

Leverage ratios show the extent a business utilizes debt. It also analyses the company solvency and capital structure. High leverage within an organization’s capital structure may be risky, though it does provide significant benefits. The use of leverage is also advantageous when the organization is earning profits as they are intensified. A highly leveraged firm in the capital structure may be somewhat risky, but there are significant benefits.

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The use of leverage is great when the company is earning profits because it can amplify. Though, an organization with high levels of leverage will be problematic if there is a decline in profitability and maybe at a bigger risk for default compared to those organizations that do not have high leverage in the same situation. Similarly, the analysis of the existing debt levels is crucial so that creditors consider it when assessing if a company should be granted more revenue as debt.

If the leverage can increase the level of the earnings, it can also upgrade the risk. Having high operating financial leverage may ultimately be risky for businesses. High leverage ratios show that the company is generating few sales though there are high costs covered. That would mean a low-income target to cover the expenses, and there would not be a lot of earnings for the company.

Chris Douthit
Chris Douthit

Chris Douthit, MBA, CSPO, is a former professional trader for Goldman Sachs and the founder of OptionStrategiesInsider.com. His work, market predictions, and options strategies approach has been featured on NASDAQ, Seeking Alpha, Marketplace, and Hackernoon.