What are Leverage Ratios?
Leverage ratios are used in determining the amount of debt loan the business has taken on the assets or equity of the business, a high ratio indicates that the company has taken a large amount of debt than its capacity and that they will not be able to service the obligations with the on-going cash flows. It includes analysis of debt to equity, debt to capital, debt to assets and debt to EBITDA.
In this article, we will look at the top leverage ratios, their interpretations, and how to calculate them.
Let’s get started.
#1 – Debt Equity Ratio
The most common leverage ratio is the debt-equity ratio. Through this ratio, we get an idea about the capital structure of the company.
Debt Equity Ratio Formula
The formula of this ratio is as follows –
Debt Equity Ratio Interpretation –
Debt Equity ratio helps us see the proportion of debt and equity in the capital structure of the company. For example, if a company is too dependent on debt, then the company is too risky to invest in. On the other hand, if a company doesn’t take debt at all, it may lose out on the leverage.
Debt Equity Ratio Practical example
Company Zing has a total equity of $300,000 and total debt of $60,000. Find out the debt-equity leverage ratio of the company.
This is a simple example.
- Debt Equity Ratio = Total Debt / Total Equity
- Or, Debt Equity Ratio = $60,000 / $300,000 = 1/5 = 0.2
That means the debt is not quite high in Company Zing’s capital structure. That means it may have a solid cash-inflow. After looking into other ratios and the financial statements, an investor can invest in this company.
PepsiCo Debt Equity Ratio
Below is the graph that plots PepsiCo Leverage Ratio calculations over the past 7-8 years.
source: ycharts
Pepsi’s Financial Leverage was around 0.50x in 2009-2010, however, Pepsi’s debt to equity ratio has increased over the years and is currently at 3.38x.
Also, you may have a look at this detailed article on Financial Leverage
#2 – Debt Capital Ratio
This leverage ratio calculation is the extension of the previous ratio. Instead of doing a comparison between debt and equity, this ratio would help us see at capital structure holistically.
Debt Capital Ratio Formula
The formula of this ratio is as follows –
Debt Capital Ratio Interpretation
This leverage ratio will help us understand the exact proportion of debt in the capital structure. Through this ratio, we will get to know whether a company has taken a higher risk of feeding its capital with more loans or not.
Debt Capital Ratio example
Company Tree’s capital structure consists of both equity and debt. Its equity is $400,000 and the debt is $100,000. Calculate the debt capital leverage ratio of Company Tree.
Let’s use the formula to find out the ratio.
- Total debt = $100,000
- Total equity = $400,000
- Total Capital = ($100,000 + $400,000) = $500,000
Putting the values in the formula, we get –
- Debt Capital Ratio = Total Debt / (Total Equity + Total Debt)
- Or, Debt Capital Ratio = $100,000 / $500,000 = 0.2
That means the debt is just 20% of the total capital of Company Tree. From the figure, we get that it’s a high equity company and low debt company.
Debt Capital Ratio of Oil & Gas Companies
Below is the Capitalization ratio (Debt Capital Ratio) graph of Exxon, Royal Dutch, BP, and Chevron.
source: ycharts
We note that this ratio has increased for most of the Oil & Gas companies. This is primarily due to a slowdown in commodity (oil) prices and thereby resulting in reduced cash flows, straining their balance sheet.
Also, for further understanding, you may have a look at this article on Capitalization Ratio
#3 – Debt-Assets Ratio
How much debt a company takes to source its assets would be known by the debt-assets ratio. This leverage ratio can be an eye-opener for many investors.
Debt Asset Ratio Formula
The formula of this ratio is as follows –
Debt Asset Ratio Interpretation
This leverage ratio talks about how much assets can be sourced through debt. In other words, if assets are more than debt (in the ratio), that means it’s rightly leveraged. But if the assets are less than debt, then the firm needs to look at the utilization of its capital.
Debt Asset Ratio Example
Company High has total assets of $500,000 and total debt of $100,000. Find out the debt-assets leverage ratio.
Let’s put in the figures in the ratio –
- Debt-Assets Ratio = Total Debt / Total Assets Or, Debt-Assets Ratio = $100,000 / $500,000 = 0.2.
That means Company High has more assets than the loans which are quite a good signal.
#4 – Debt EBITDA Ratio
This leverage ratio is the ultimate ratio that finds out how much impact debt has on the earnings of a company. You may ask why? Because, here we’re talking about EBITDA, i.e. earnings before interests, taxes, depreciation, and amortization. And since a company needs to pay interests (cost of debt), this ratio will have a huge impact on the company’s earnings.
Debt EBITDA Formula
The formula of this ratio is as follows –
Debt EBITDA Interpretation
The reason this ratio is important is that if we know how much debt the company has, compared to how much the company earns before paying out the interests; we would know how debt can affect the earnings of the company. For example, if the debt is more, the interests would be more (possibly, if the cost of debt is higher) and as a result, the taxes would be less and vice versa.
Debt EBITDA example
Company Y has a debt of $300,000 and in the same year, it reported an EBITDA of $60,000. Find out the Debt EBITDA leverage ratio.
Let’s put in the figure to find out the ratio.
- Debt EBITDA Ratio = Total Debt / EBITDA
- Or, Debt EBITDA Ratio = $300,000 / $60,000 = 5.0
If this ratio scores higher, it means that debt is higher than the earnings and if this ratio scores lower, debt is relatively lower compared to earnings (it’s a great thing).
Also, have a look at this detailed discussion on Debt EBTIDA in DSCR Ratio
Why do you need to look at leverage ratios?
As investors, you need to look at everything. Leverage ratios will help you how a company has structured its capital.
Many companies don’t like to take loans from outside. They believe that they should fund all their expansion or new projects through equity.
But to take advantage of leverage, it’s important to structure the capital with a portion of the debt. It helps reduce the cost of capital (by reducing the cost of equity, it is huge). Plus, it also helps in paying less tax since the taxes are calculated after paying the interests (i.e. the cost of debt).
As investors, you need to look at companies and calculate the above ratios. You would get clarity about the company is able to take advantage of the leverage or not. If the company has taken too much debt, it’s too risky to invest in the company. At the same time, if a company doesn’t have any debt, it may pay off too much in cost of capital and actually reduce their earnings in the long run.
But only leverage ratios won’t help. You need to look at all the financial statements (especially four – cash flow statement, income statement, balance sheet, and shareholders’ equity statement) and all other ratios to get a concrete idea about how a company is doing. However, it surely does help investors in deciding whether a company is taking advantage of the leverage or not.
Video on Leverage Ratios
Suggested Readings
Guide to Leverage Ratios. Here we discuss the formula to calculate leverage ratios including Debt Equity Ratio, Debt Capital Ratio, Debt Asset Ratio, and Debt EBITDA Ratio. Additionally, you may look at the following suggested readings –
