How To Use Leverage Ratio To Manage Debt Effectively

What is leverage?

Before we get to leverage ratio, what does leverage mean?

Leverage is when organisations (and individuals) use debt instead of cash or equity to achieve a financial goal in the hope of generating more income. Taking out a loan or issuing corporate bonds to investors are ways in which corporations take on debt to fund their business plans. Here are some scenarios of companies using leverage:

• Availing of asset-based lending, or taking out a loan secured by assets.
• Receiving a cash flow loan. The lender provides the funds after assessing the company’s cash flow generation capacity. Such loans are usually availed of by small businesses that don’t have a long credit history.
• Making a leveraged buyout, which involves acquiring a company using debt.

While the word debt has a negative undertone, it has definite advantages. Most businesses prefer to borrow than to use their equity or sell their assets to finance a project or investment. Borrowing doesn’t require you to give up ownership rights in the company, which you would if you issued new stock to raise cash. Additionally, debt is tax-deductible, making it a cheaper financing option. What’s more, taking out a loan or line of credit significantly increases one’s buying power and, potentially, the expected return on investment.

What is leverage ratio and why is it important?

Businesses that use debt financing must not neglect their financial leverage ratio. The leverage ratio compares a company’s total debt to its equity or total assets, as listed in its balance sheet or income statement. You can use the leverage ratio to assess how much debt you can take on to improve your capital without the risk of default. Just remember, too much leverage can be dangerous. It’s critical to identify the point beyond which taking on more debt will be counterproductive.

Another factor that makes the financial leverage ratio important is that it impacts one’s borrowing power. A lender might check a company’s leverage ratio to assess its ability to pay a debt before approving its loan request. Similarly, investors might study the leverage ratio to check a company’s financial health and risk level before deciding to invest in it.

Role of leverage ratio in banking

While talking about leverage ratio, banks deserve a special mention. Banks are among the most leveraged institutions. They tend to have a higher leverage ratio than non-banks because they are in the business of facilitating leverage to others, in turn ensuring the smooth functioning of the overall economy. Many may argue that banks deliberately keep their leverage ratios high, safe in the knowledge that a government bailout is all but certain in the event of a banking crisis, which would have a disastrous economic fallout.

The belief that banks are excessively leveraged has prompted demands for more regulation and risk management within the sector. Soon after the 2008 Great Financial Crisis, caused in part by allegedly lax lending, the Basel III rules were introduced. Approved by the Basel Committee on Banking Supervision in 2010-11, the Basel III rules sought to increase bank liquidity and reduce bank leverage globally. A new minimum leverage ratio of 3% was introduced, making it mandatory for banks to have a leverage ratio of 3% or more. The Basel III leverage ratio is calculated by dividing a bank’s Tier 1 capital by its average total consolidated assets. Tier I capital includes assets that can be easily liquidated in a crisis, such as common shares, retained earnings, other comprehensive income, reserves, and so on. Consolidated assets are as reported on the bank’s income statement. The Basel leverage ratio is also called the Tier I leverage ratio.

Types of leverage ratios, with formulas

There are several financial leverage ratios in use, with each one meant to measure leverage from a distinct perspective: 

1. Debt-to-asset ratio

The debt-to-asset ratio compares a company’s debt to its assets. It represents the portion of assets that are financed by liabilities. The associated leverage ratio formula is:

Debt-to-asset ratio = Total debt / Total assets

The higher the ratio, the greater the proportion of debt funding and, in turn, default risk. A debt-to-asset ratio of 1 is considered risky as it indicates that a company’s assets are 100% debt-funded. However, a low ratio might be problematic, too, and point to poor decision-making. By comparing a company’s debt-to-asset ratio with those of rival businesses in the same industry, one can analyse its ability to raise more capital by taking on more debt.

2. Debt-to-equity ratio

The debt-to-equity (D/E) ratio compares a company’s debt to its shareholder equity (investments plus earnings over time). A tool to assess debt capacity like the debt-to-asset ratio, the D/E ratio measures the degree to which a business finances its operations with external borrowings instead of its own resources. The leverage ratio formula to use here is:

Debt-to-equity ratio = Total debt / Shareholder equity

A higher D/E ratio means greater debt reliance but also a higher expected return on investment. A lower ratio stands for fewer liabilities and more financial stability. However, it could also point to a conservative approach to doing business. If a company’s debt-to-equity ratio is higher than the industry standard, it might find it hard to get new financing. A D/E ratio of under 1 is considered ideal.

3. Debt-to-capital ratio

The debt-to-capital ratio compares a company’s interest-bearing debt to its capital, where capital includes debt plus shareholder equity.

Debt-to-capital ratio = Debt / (Debt + Shareholder equity)

The higher the debt-to-capital ratio, the greater the reliance on debt-funding rather than on equity-funding. This, in turn, increases the chances of the company being unable to cover its liabilities and default on payment. The debt-to-capital ratio tells investors and lenders how risky it is to invest in a business.

4. Debt-to-EBITDA ratio

Debt-to-EBITDA ratio = Debt / EBITDA

In this leverage ratio formula, EBITDA stands for earnings before interest, taxes, depreciation and amortisation, and is representative of a company’s cash profit. The debt-to-EBITDA ratio measures how much earnings a business has in hand to pay off its debts before accounting for interest payments, taxes, depreciation, and amortisation expenses. It is a useful measure of cash flow. A high debt-to-EBITDA ratio indicates a higher debt burden. A decreasing ratio is better than an increasing ratio because it means that the business is paying off its debts and increasing its earnings. However, the debt-to-EBITDA ratio must be used with caution as it might not always give an accurate picture of earnings. For one, it doesn’t account for interest on debt, which can be a significant figure for some.

For more about debt ratios, read our article ‘Understanding Debt Ratio: Definition, Formula & Examples’

5. Asset-to-equity ratio

The asset-to-equity ratio measures how much of a company’s assets are funded by investors. The formula to calculate it is:

Asset-to-equity ratio = Total assets / Shareholder equity

A low ratio indicates greater dependence on one’s own resources and a smaller debt burden, which in turn points to a lower risk of default. However, a low ratio might also be interpreted as conservative decision-making by the business. Similarly, a high ratio can be interpreted in two ways – a business reeling under debt, or one with high returns on investment. The asset-to-equity ratio is affected by several factors, such as a company’s assets, sales, the industry, and prevailing market conditions. Businesses are advised to keep a close watch on this metric as it might impact their ability to receive additional debt or investment. Typically, an asset-to-equity ratio of less than 2 is preferred.

6. Operating leverage ratio

Operating leverage ratio is unlike any of the financial leverage ratios discussed so far. It calculates what percentage of a business’ total cost is made up of fixed costs as opposed to variable costs. Rent, taxes, and insurance are examples of fixed costs, which remain constant irrespective of the volume of production and sales. In contrast, variable costs – labour and raw material costs, utility bills, etc – change depending on how much a company produces and sells. Calculating the operating leverage ratio helps you understand how effectively you are using your fixed assets (factories, warehouses, machinery, etc). You can use the operating leverage formula to find your breakeven point and develop a pricing strategy that covers all your expenses while also earning a profit.

Operating leverage = (Sales – Variable costs) / Profits

The more profit a company earns from its fixed assets, the higher its operating leverage. However, operating leverage also depends on the industry. Businesses with heavy expenses associated with research and development and marketing (software firms, automobile manufacturers, etc) have a high operating leverage. In comparison, retail businesses have lower fixed costs and, hence, lower operating leverage.

7. Combined leverage ratio

Combined leverage involves the use of both financial leverage and operating leverage. Combined leverage is when a company uses both debt financing and fixed costs to fund a project or investment.

Leverage ratio examples

Let’s say a business has assets worth SGD 70 million and SGD 20 million in total debt. Furthermore, its equity is worth SGD 30 million and its EBITDA works out to SGD 7 million. Now, using the various leverage ratio formulas mentioned above, let’s calculate.

1. First, the debt-to-equity (D/E) ratio.

Debt-to-equity ratio = Total debt / Shareholder equity

Debt-to-equity ratio = 20 / 30 = 0.666

A D/E ratio of 0.66 signifies that for every dollar of equity, the company has 66 cents in leverage.

2. Next, the debt-to-asset ratio.

Debt-to-asset ratio = Total debt / Total assets

Debt-to-asset ratio = 20 / 70 = 0.285

A 0.285 debt-to-asset ratio means that 28.5% (0.285 x 100) of the company’s assets is debt-funded.

3. The next calculation is the debt-to-capital ratio. 

Debt-to-capital ratio = Debt / (Debt + Shareholder equity)

Debt-to-capital ratio = 20 / (20 + 30) = 0.4

This ratio shows us that 40% of the company’s operations are financed by debt.

4. Lastly, the debt-to-EBITDA ratio.

Debt-to-EBITDA ratio = Debt / EBITDA

Debt-to-EBITDA ratio = 20 / 7 = 2.857

A ratio of 2.857 means that the company’s total debt is around 2.8 times larger than its EBITDA.

Leverage ratio vs net leverage ratio

What differentiates net leverage ratio from leverage ratio is that it takes into account a company’s cash and cash equivalents. Net leverage ratio is calculated by subtracting cash and cash equivalents from total debt and then dividing the outcome by assets. Leverage ratio does not account for cash and cash equivalents, which are a company’s most liquid assets. Because it acknowledges available liquidity, the net leverage ratio is said to present a more accurate picture of a company’s actual debt level and its ability to repay borrowed funds. The net leverage ratio can be called a liquidity metric. Both ratios are important because lenders and investors might examine the two in conjunction to fully understand a company’s ability to repay its debts while pursuing higher growth and earnings.

Leverage ratio vs gearing ratio

The terms leverage ratio and gearing ratio are often used interchangeably, and with good reason. Both measure financial leverage. However, a tiny difference is that leverage is associated with debt while gearing refers to debt and equity. Rather than a single ratio, gearing ratio is an umbrella term for a group of ratios that compare the equity and debt of businesses. The most prominent and widely used gearing ratio is the debt-to-equity ratio, which is also a leverage ratio as previously mentioned. To sum up, the leverage ratio and gearing ratio both assess financial stability but from different angles.

Leverage ratio vs coverage ratio

Coverage ratios are a category of financial ratios that reveal a company’s ability to take care of its financial obligations. There are four commonly used coverage ratios. The interest coverage ratio measures ability to pay the interest expense on a debt. The debt service coverage ratio reveals if a business can repay its entire debt, including the principal amount and interest. Similarly, you can use the cash coverage ratio to know if you can pay your interest expense with available cash. Meanwhile, the asset coverage ratio looks at the ability to use assets to pay off a debt. Coverage ratios are used together with leverage ratios to better understand a business’ debt repayment capability.

What is a good leverage ratio?

Financial leverage allows companies to increase their return on investment, pursue growth opportunities, and earn profits that might otherwise not have been possible. And in the process, they also get relief in the form of tax deductions. Given the importance of debt financing, one might ask what a good leverage ratio is. A leverage ratio of 1 shows that a company’s debts are equal to its equity. So, logically, a leverage ratio of less than 1 is considered safe while a ratio of 0.5 or less is even better as it means that a business has twice as many assets as it has liabilities. That said, a ‘good leverage ratio’ is a subjective topic. Financial leverage is affected by multiple factors, including business size, industry, competition, and organisational goals. Businesses that exist in a highly competitive space may be pushed to take on more leverage to stay in contention. Entrepreneurs with high ambition are willing to take on more leverage than their counterparts who prefer to play it safe. Furthermore, what is a good leverage ratio is also dependent on the specific leverage ratio being used. A good leverage ratio for one business might not be the same for another. But it’s always good practice to monitor the industry standard, which can help you arrive at an acceptable ratio.

What does a high leverage ratio mean?

Again, the answer depends on the leverage ratio in question. For the debt-to-equity ratio, a figure of 2 and above is considered high. For others, a ratio of 1 might be risky. What businesses must remember when they take on debt is that there are associated dangers. First, the risk of default, which can have serious consequences, such as bankruptcy and foreclosure. Second, high interest rates and financing costs, which might prove a heavy financial burden, especially when returns fail expectations.

To conclude, using financial leverage can be more rewarding if companies approach it with less aggression and more caution.

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