by 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 is useful in evaluating whether it can pay off its debts as they come due. A leverage ratio is any kind of financial ratio that indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. These ratios provide an indication of how the company’s assets and business operations are financed (using debt or equity).
There are several different leverage ratios that may be considered by market analysts, investors, or lenders. Some accounts that are considered to have significant comparability to debt are total assets, total equity, operating expenses, and incomes.
Debt-to-Equity Ratio = Total Debt / Total Equity
Debt-to-Assets Ratio = Total Debt / Total Assets
Debt-to-Capital Ratio = Today Debt / (Total Debt + Total Equity)
Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)
Asset-to-Equity Ratio = Total Assets / Total Equity
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. Fixed and variable costs are the two types of operating costs; depending on the company and the industry, the mix will differ.
A higher financial leverage ratio indicates that a company is using debt to finance its assets and operations often a telltale sign of a business that could be a risky bet for potential investors.
It can mean that earnings will be inconsistent, it could be a while before shareholders can see a meaningful return on their investment, or the business could soon be insolvent.
Creditors also rely on these metrics to determine whether they should extend credit to businesses. If a company’s financial leverage ratio is excessive, it means they’re allocating most of its cash flow to paying off debts and is more prone to defaulting on loans.
A prospective lender may use leverage ratios as part of its analysis of whether to lend funds to a business. However, these ratios do not provide sufficient information for a lending decision. A lender also needs to know if a business is generating sufficient cash flows to pay back debt, which involves a review of both the income statement and statement of cash flows. A lender will also review a company’s budget, to see if projected cash flows can continue to support ongoing debt payments.
Creation:
A business can increase its leverage in a number of ways. The most obvious approach is to take on more debt through a line of credit, where the debt reflects a general increase in the obligations of a firm. A business might also increase its leverage in a more specific manner, such as by taking on a lease obligation when it acquires a specific asset, or when it borrows funds in order to acquire another business. It might also acquire debt in order to conduct a stock buyback, which represents a deliberate increase in leverage, usually to increase the return on investment of the firm’s investors.
