What Is a Leverage Ratio?
A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans) or assesses the ability of a company to meet its financial obligations. The leverage ratio category is important because companies rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a company helps evaluate whether it can pay off its debts as they come due. Several common leverage ratios are discussed below.
KEY TAKEAWAYS
- A leverage ratio is any one of several financial measurements that assesses the ability of a company to meet its financial obligations.
- A leverage ratio may also be used to measure a company’s mix of operating expenses to get an idea of how changes in output will affect operating income.
- Common leverage ratios include the debt-equity ratio, equity multiplier, degree of financial leverage, and consumer leverage ratio.
- Banks have regulatory oversight over the level of leverage they are can hold.
For example, United Parcel Service’s long-term debt for the quarter ending December 2019 was $21.8 billion. United Parcel Service’s total stockholders’ equity for the ending of December 2019 was $3.3 billion. The company’s D/E for the quarter was 8.62. That is considered high.3
A high debt/equity ratio generally indicates that a company has aggressively financed its growth with debt. This can result in volatile earnings due to the additional interest expense. If the company’s interest expense grows too high, it may increase the company’s chances of a default or bankruptcy.
Typically, a D/E ratio greater than 2.0 indicates a risky scenario for an investor; however, this yardstick can vary by industry. Businesses that require large capital expenditures (CapEx), such as utility and manufacturing companies, may need to secure more loans than other companies. Measuring a firm’s leverage ratios against past performance and with companies operating in the same industry is a good idea to understand the data better. Fedex has a D/E ratio of 1.78, so there is cause for concern where UPS is concerned. However, most analysts consider that UPS earns enough cash to cover its debts.
The Equity Multiplier
The equity multiplier is similar but replaces debt with assets in the numerator:
or example, assume that Macy’s (NYSE: M) has assets valued at $19.85 billion and stockholder equity of $4.32 billion. The equity multiplier would be:
$19.85 billion÷$4.32 billion=4.59$19.85 billion÷$4.32 billion=4.59
Although debt is not specifically referenced in the formula, it is an underlying factor given that total assets include debt.
Remember that Total Assets = Total Debt + Total shareholders’ Equity. The company’s high ratio of 4.59 means that assets are mostly funded with debt than equity. From the equity multiplier calculation, Macy’s assets are financed with $15.53 billion in liabilities.
The equity multiplier is a component of the DuPont analysis for calculating return on equity (ROE):
The Debt-to-Capitalization Ratio
An indicator that measures the amount of debt in a company’s capital structure is the debt-to-capitalization ratio, which measures a company’s financial leverage. It is calculated as:
Operating leases are capitalized in this ratio, and equity includes common and preferred shares. Instead of using long-term debt, an analyst may decide to use total debt to measure the debt used in a firm’s capital structure. In this case, the formula would include minority interest and preferred shares in the denominator.
Degree of Financial Leverage
Degree of financial leverage (DFL) is a ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income due to changes in its capital structure. It measures the percentage change in EPS for a unit change in earnings before interest and taxes (EBIT) and is represented as:
DFL can alternatively be represented by the equation below:
This ratio indicates that the higher the degree of financial leverage, the more volatile earnings will be. Since interest is usually a fixed expense, leverage magnifies returns and EPS. This is good when operating income is rising, but it can be a problem when operating income is under pressure.
The Consumer Leverage Ratio
The consumer leverage ratio is used to quantify the amount of debt the average American consumer has relative to their disposable income.
Some economists have stated that the rapid increase in consumer debt levels has been a contributing factor to corporate earnings growth over the past few decades. Others blamed the high level of consumer debt as a major cause of the great recession.
Understanding how debt amplifies returns is the key to understanding leverage. Debt is not necessarily a bad thing, particularly if the debt is taken on to invest in projects that will generate positive returns. Leverage can thus multiply returns, although it can also magnify losses if returns turn out to be negative.
The Debt-To-Capital Ratio
The debt-to-capital ratio is a measurement of a company’s financial leverage. It is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a company’s total capital base. Debt includes all short-term and long-term obligations. Capital includes the company’s debt and shareholders’ equity.
This ratio evaluates a firm’s financial structure and how it finances operations. Typically, if a company has a high debt-to-capital ratio compared to its peers, it may have a higher default risk due to the effect the debt has on its operations. The oil industry seems to have about a 40% debt-to-capital threshold. Above that level, debt costs increase considerably.
The Debt-To-EBITDA Leverage Ratio
The debt-to-EBITDA leverage ratio measures a company’s ability to pay off its incurred debt. Commonly used by credit agencies, this ratio determines the probability of defaulting on issued debt. Since oil and gas companies typically have a lot of debt on their balance sheets, this ratio is useful in determining how many years of EBITDA would be required to pay back all the debt. It can be alarming if the ratio is over 3, but this can vary depending on the industry.
The Debt-To-EBITDAX Ratio
Another variation of the debt-to-EBITDA ratio is the debt-to-EBITDAX ratio, which is similar, except EBITDAX is EBITDA before exploration costs for successful efforts companies. This ratio is commonly used in the United States to normalize different accounting treatments for exploration expenses (the full cost method versus the successful efforts method).
Exploration costs are typically found in the financial statements as exploration, abandonment, and dry hole costs. Other noncash expenses that should be added back in are impairments, accretion of asset retirement obligations, and deferred taxes.
The Interest Coverage Ratio
Another leverage ratio concerned with interest payments is the interest coverage ratio. One problem with only reviewing the total debt liabilities for a company is they do not tell you anything about the company’s ability to service the debt. This is exactly what the interest coverage ratio aims to fix.
This ratio, which equals operating income divided by interest expenses, showcases the company’s ability to make interest payments. Generally, a ratio of 3.0 or higher is desirable, although this varies from industry to industry.
The Fixed-Charge Coverage Ratio
Times interest earned (TIE), also known as a fixed-charge coverage ratio, is a variation of the interest coverage ratio. This leverage ratio attempts to highlight cash flow relative to interest owed on long-term liabilities.
To calculate this ratio, find the company’s earnings before interest and taxes (EBIT), then divide by the interest expense of long-term debts. Use pre-tax earnings because interest is tax-deductible; the full amount of earnings can eventually be used to pay interest. Again, higher numbers are more favorable.
- FDIC. “Capital,” Page 2. Accessed August 14, 2020
- Federal Reserve. “Bank Holding Company Supervision Manual,” Page 1-54. Accessed August 14, 2020.
- United Parcel Service. “2019 Annual Report,” Page 2. Accessed August 14, 2020.