Formula to Calculate Leverage Ratios (Debt/Equity)
The formula for leverage ratios is basically used to measure the debt level of a business relative to the size of the balance sheet. The calculation of leverage ratios are primarily by comparing the total debt obligation relative to either the total assets or the equity contribution of business.
A high leverage ratio calculates that the business may have taken too many loans and is in too much debt compared to the ability of the business to reasonably service the debt with the future cash flows. The two key leverage ratios are:
Steps to Calculate Leverage Ratios (Debt and Debt to Equity Ratio)
Debt Ratio:
This leverage ratio formula basically compares assets to debt and is calculated by dividing the total debt by the total assets. A high ratio means that a huge portion of the asset purchases is debt-funded.
The formula debt ratio can be calculated by using the following steps:
- Step #1: Firstly, the total debt (includes a short term as well as long term funding) and the total assets is collected which is easily available from the balance sheet.
- Step #2: Finally, the debt ratio is calculated by dividing the total debt by the total assets.
Debt to Equity Ratio:
This leverage ratio formula basically compares equity to debt and is calculated by dividing the total debt by the total equity. A high ratio means that the promoters of the business are not infusing the adequate amount of equity to fund the business resulting in a higher amount of debt.
The formula of debt to equity ratio can be calculated by using the following steps:
- Step #1: Here, the total debt and the total equity both are collected from the liability side of the balance sheet.
- Step #2: Finally, the debt to equity ratio is calculated by dividing the total debt by the total equity.
Examples of Leverage Ratios Calculation
Example #1
Let us assume a company with the following financial for the current year. Use the calculation of Leverage Ratios for the same.
From the above table, the following can be calculated,
#1 – Total Debt
Total debt = Long term bank loan + Short term bank loan
So the total debt will be = $36,000
#2 – Debt Ratio
Debt ratio = Total debt / Total assets
So, the calculation of the Debt ratio will be as follows –
Debt Ratio will be –
#3 – Debt to Equity Ratio
Debt to equity ratio = Total debt / Total equity
So, the calculation of Debt to equity ratio will be as follows –
Debt to Equity Ratio will be-
Example #2
Let us take an example of a real company Apple Inc. with the following financial for the year ended on September 29, 2018 (all amounts in USD millions)
From the above table, the following can be calculated,
#1 – Total Debt
Total debt = Long term bank loan + Short term loan
Total Assets will be:
#2 – Total Equity
Total equity = Paid-in equity capital + Retained earnings + Comprehensive income / (loss)
So from the above calculation Total Equity will be:
#3 – Debt Ratio
Therefore, Debt ratio = Total debt / Total assets
Calculation of Debt Ratio will be –
So from the above calculation Debt Ratio will be:
#4 – Debt to Equity Ratio
And, Debt to equity ratio = Total debt / Total equity
Calculation of Debt to Equity Ratio will be –
- Debt to equity ratio = $114,483 / $107,147
Calculation of Debt to Equity Ratio-
So, from the above calculation Debt to equity ratio will be:
Relevance and Use
The concept of leverage ratios is very essential from a lender’s vantage point as it is a measure of risk to check if a borrower can pay back its debt obligations. However, a reasonable amount of leverage can be seen as advantageous to the shareholders since it indicates that the business is optimizing its use of equity to fund operations which eventually increases the return on equity for the existing shareholders.
The assessment of the leverage ratios form is an important part of a prospective lender’s analysis of whether to lend to the business. However, the leverage ratios formula per se does not offer sufficient information for a lending decision since it is a relative indicator and has to be seen in conjunction with the absolute figures. The lender is required to review both the income statement and cash flows statement to check if the business is generating adequate cash flows to pay back the debt. The lender is also required to review the projected cash flows to check if the business can continue to support debt payments in the future. As such the leverage ratios formula are used as a part of the analysis to determine whether it is safe to lend money to the business given its debt servicing ability.
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This has been a guide to Leverage Ratios Formula. Here we learn how to calculate the Leverage ratios i.e debt ratio and debt to equity ratio along with some practical examples and downloadable excel template. You can learn more about financial analysis from the following articles –
