What is leverage ratio Formula?

A leverage ratio is a kind of financial ratio that provides help for measuring a company’s various debt levels. It is a measurement that also helps in determining a sustainable company towards its various borrowing practices. As a measure, the proportion of equity to assets is part of the leverage ratio. Simply put, it also captures all debts or liabilities regardless of their listing.

Normally, businesses need in the form of debt and equity as finance. Not only they need finance for expanding their operations, but also to purchase assets, for acting as sufficient working capital, and also for debt restructuring. This money comes from investors and financial institutions.

For generating earnings, businesses have to control their debts. If the return on investment is earned on capital and is higher than the interest paid on loans and liabilities, then the shareholders’ wealth will increases.

Financials Leverage Ratio = Average Total Assets / Average Equity

Operating Leverage = Fixed Cost / Variable Cost

Understanding Leverage Ratio Formula

Leverage ratio is referred to the proportion of debt that is compared to the equity or capital. Banking institutions often use it for tracking finances. However, businesses are also making use of this ratio. A company’s financial leverage ratio indicates the level of debt in comparison to its accounts, such as the income statement, statement of cash flow, or balance sheet.

How Leverage Ratio Formula is used?

Leverage ratios are essential for measuring the risk since a borrower who cannot pay back its debt obligations is having a considerable risk of entering bankruptcy protection.

However, a modest amount of leverage can also benefit shareholders since it can mean that the business is minimizing its use of equity for funding its operations, which also increases the return on equity for all existing shareholders.

Also, a load of higher debt may be acceptable in a monopoly or duopoly situation. The cash flows are needed for servicing its debts which tend to be more consistent over time.

A prospective lender may also use leverage ratios for analyzing that whether to lend funds to a business or not. However, these ratios cannot provide sufficient information to lend a decision. A lender may also need to know that if a business can generate a sufficient cash flow to pay back its debts, it also involves reviewing both the income statements and cash flow statements.

A lender will also review a company’s budget to see if projected cash flows can continue supporting its ongoing debt payments. In addition to this, the nature of the industry in which the business is located plays a significant role in lending the decision.

E.g., if an industry has few competitors, then there are high barriers to entering, and there is also a long history of above-average profits. An organization can also probably maintain a very high debt load over a long period.

Conversely, in an industry where the market share is changing continually, product cycles are also short, and capital investment requirements are also high. It can also be quite difficult to have stable cash flows, and in this, lenders will be less inclined to lend money.

In short, leverage ratios can be used as a portion of the analysis while determining whether to lend money. Still, a great deal of additional information is needed before it can make a lending decision.

What does Leverage Ratio Formula represents?

Many investors know that too much debt is a very risky proposition. If a company can generate higher return rates than the interest rates and repay its loans, then the debt might be a useful tool for growth.

The leverage ratio can also assess this level of risk by showing you the proportion of debt to assets or cash.
There are also operational leverage ratios, which are separate from finance leverage ratios.

This type of formula shows how changes in operational output or expenses will impact income. The third type of leverage ratio relates to consumer debt, which is compared to disposable income. It is used to assess creditworthiness or in a more exhaustive fiscal analysis.

How to calculate Leverage Ratio Formula ?

Usually, there are only a few different types of leverage ratios that usually falls under the financial leverage ratio. Below points teaches us about how to calculate three of them using data found on your balance sheet or company’s general ledger:

Operating Leverage Ratio Formula

The operating leverage ratio is used for measuring the ratio of a business contribution margin with its net operating income. It also evaluates that how much a business income is changing, which is relative to its changes in sales.
It’s calculated using the following formula:

Operating Leverage = Revenue – Variable Cost / Revenue – Variable Cost – Fixed Cost

Degree of Financial Leverage Ratio Formula

The net leverage ratio of the net debt to the earnings before interest, taxes, depreciation, and amortization is used for measuring a business’s debt to earnings. It also reflects how long it would take a business to pay back its debt and EBITDA were constant.

It can be calculated by using the following formula:

DFL = % of change in EPS / % of Change in EBIT

Debt to Equity Ratio

The debt to equity ratio is basically used for measuring the ratio of a business’s total liabilities with its stockholders’ equity. It also offers a glance look at the value of a business relative to its debts.
It’s calculated using the following formula:

This ratio can widely vary depending on the industry and products or services it sold. For example, General Motors had a debt to equity ratio of 5.03 in the 2017 fiscal year, reflecting the high costs of establishing, staffing, and running vehicle manufacturing operations around the world.

What are the types of Leverage Ratio Formula ?

There are several types of leverage ratios like primarily financial ratio, operational ratio, and consumer ratio.
Although most of them factor debt into the equation, the other component of the ratio could be equity, capital, or assets.
Therefore, the leverage ratio formula could be written in several ways, depending on what’s being compared to your outstanding debt or assets:

Debt to (EBITDA) – This ratio measures the capacity or potential of a company for paying off its debts. Typically it is used by financial institutions and credit rating agencies; the Debt to EBITDA ratio helps determine how efficiently the company can clear its debts.

The formula is Debt to EBITDA = (Total Debt/EBITDA (Earnings before Interest Taxes, Depreciation, and Amortization)).

Debt to Total Asset – this ratio measures the relation of a company’s assets to its total debt. Simply put, the ratio helps to measure how much debt the company used in purchasing assets. The formula is Debt to Asset = (Total Asset/Total Assets).

Equity debt – this ratio measures the proportion of a company’s equity and debt. Commonly used by the banking industry as part of its credit appraisal exercises, the ratio compares the bank’s investment in the business to the investment made by the owners. The formula is Debt to Equity = (Total Debt/Total Equity).

What Is a Good Leverage Ratio Formula ?

In general, those ratios that fall between 0.1 and 1.0 are considered most desirable by most businesses. Having a leverage ratio of 1, which is also generally considered the ideal leverage ratio, indicates that the company has equal amounts of debt and the other comparable metric.

On the other hand, any leverage ratio that is higher than one is usually considered alarming; this means that the company has incurred massive amounts of debt and is also facing the risk of not paying off its debt obligations as they come due.

How leverage is created?

A business can increase its leverage in several ways. The most obvious way is to take on more debt through a line of credit, where the debt reflects a general increase in a firm’s obligations.

Maybe a business can also increase its leverage more specifically by taking on a lease obligation whenever it is acquired as a specific asset or borrowing funds to acquire another business.

It might also acquire debt for conducting a stock buyback, representing a deliberate increase in leverage, which can usually increase the return on investment of the firm’s investors.

What risks of high high financial leverage and operating leverage ?

If leverage ratio can be used for multiplying earnings, it can also multiply various risks. Having both high operating ratios and financial leverage ratios can be very risky for a business. Illustrating a high operating leverage ratio of a company generating few sales yet has high costs or margins that need to be covered.

It may result in a lower income target or insufficient operating income to cover other expenses and result in negative earnings for the company. On the other hand, high financial leverage ratios occur when the return on investment (ROI) does not exceed the interest paid on loans. It will significantly decrease the company’s profitability and earnings per share.

Bank and Leverage Ratio Formula

Banks are the most leveraged institutions in the United States. It combines fractional-reserve banking and Federal Deposit Insurance Corporation (FDIC) protection, producing in a banking environment with very limited lending risks.
For this compensation, three separate regulatory bodies, such as the FDIC, the Federal Reserve, and the Comptroller of the Currency, can review and restrict the leverage ratios for all American banks.

It means that they restrict how much money a bank can lend relative to how much capital the bank devotes to its assets. The level of capital is also important because banks can even “write down” the capital portion of their assets if their total asset values dropdown. It cannot write down assets financed by debt because the bank’s bondholders and depositors can also owe those funds.

M-Banking regulations for leverage ratios can also be complicated. The Federal Reserve can create guidelines for various bank holding companies, although these restrictions may vary and depend on the ratings assigned to the bank. In general, if the bank is experiencing rapid growth or facing operational or financial difficulties, then it must maintain higher leverage ratios.

It can place various types of capital requirements and minimum reserve on American banks through the FDIC and the currency that can indirectly impact leverage ratios. The level of scrutiny paid for the leverage ratios had increased since the Great Recession of 2007 to 2009 when all the banks were “too big to fail” was a calling card for making banks more solvent.

These restrictions can naturally limit the number of loans and make itis more difficult and expensive for a bank to raise capital than borrowing funds. Higher capital requirements can also reduce the dividends or dilute share values if more shares are issued.
In the case of the banks, the tier 1 leverage ratio is most commonly used by the regulators.

Explanation of the Leverage Ratio Formula ?

If a bank keeps all of its deposits as cash in bank vaults, it would have a large quantity of liquid capital. Whenever a customer demands his deposits back, the bank can go to the bank vaults and pay everything back.

It is also a very conservative method of banking. The bank will not have to worry about a decline in the value of assets or loans which are not paid back. However, this type of banking is not much very profitable. By keeping these capital reserves in the bank vaults, it does not earn you any money.

Instead, the bank will be lending a percentage of its deposits to customers who would be wishing to take out a loan. It enables firm for gaining a better rate of return on deposits. More bank lends which will greater the potential to make a profit. It is leverage.

Increase in the Leverage Ratio Formula

Many regulators are considered in raising the leverage ratio. It means that banks will have to keep more capital reserves. Increasing capital reserves to meet higher leverage ratios requires selling assets to get cash or reducing lending.

A higher leverage ratio can decrease banks’ profitability because it can also mean that banks can also do less profitable lending.

However, increasing the leverage ratio can mean that more capital reserves can survive a financial crisis more easily.
Governments are keen on increasing the leverage ratio because it can make it less likely governments will have to bail them out.

Leverage ratio in the credit boom and bust-

In the booming financial years of 2000-2007, banks have to increase their leverage. Leverage ratios can fall as they can decrease the capital buffer they had.
The motive for increasing the lending’s was that they could try to increase profitability. Also, banks have little concern about going bankrupt because there is an implicit guarantee that the government will be bailing out banks.

After the 2007 credit crunch, all the banks became exposed to bad debts. A small loss of equity can mean that many banks can become illiquid, and they can be short of cash because they might lend a high percentage of their assets. They might have a low leverage ratio.

It has became more difficult for any banks to raise finance on money markets because all banks are trying raise cash.

Regulation on the bank leverage-

The Leverage ratio in different countries is required. There is also a global base leverage requirement of 3%, which are inset of Basel III. But, many other countries might have higher leverage requirements.
Under Federal bank regulations, a United States bank must have a Tier 1 Capital ratio of at least 4%. The United States is also considered in raising the leverage ratio to 5%.

UK Regulation Chancellor has recently announced that he will likely be supporting a new regulation that sets bank leverage ratios by 2018. The European Bank Association are also working on bank leverage ratios.

Conclusion

The leverage ratio is one of the important tools used in measuring a company’s inherent risk, which showcases how it is used for borrowing money to finance its operations and assets. They can also help potential investors or lenders judge a business’s health and whether it can be a smart or a risky move for getting involved with it. It also depends on the company’s level of financial leverage.

Although lower leverage ratios can be preferred over higher leverage ratios, as this rule does not apply to all businesses as leverage ratios, this may vary greatly between different industries. Therefore, it is very advisable in comparing the leverage ratios of a particular company to the leverage ratios of other companies operating in the same or similar industry.

Frequently Asked Questions:

What is a leverage ratio?

A leverage ratio is considered one of the several financial measurements that look at how much capital is coming into debt. It assesses the abilities of the company to meet its financial obligations. Banks might be having regulatory oversight on the level of leverage they are can hold.

How to calculate leverage ratio?

The below point explains the calculation of the leverage ratio:

Operating Leverage Ratio-

The operating leverage ratio is used for measuring the ratio of a contribution margin of a business to its net operating income. It evaluates that how much a business income changes, which is relative to changes in sales.

The calculation formula:

Operating Leverage Ratio = % change in EBIT / % change in sales.

Net Leverage Ratio-

The net leverage ratio of net debt to EBITDA is used to measure a business’s debt to earnings. It also reflects how long it would take a business to pay back its debt if debt and EBITDA were particularly constant.
The calculation formula:

Net Leverage Ratio = (Net Debt – Cash Holdings) / EBITDA

Debt to Equity Ratio

The debt to equity ratio basically is used for measuring the ratio of a business’s total liabilities to its stockholders’ equity. It also offers a glance look at the value of a business which is relative to its debts. The calculation formula:

Financial Leverage = Total Debt / Stockholders’ Equity

This ratio can also vary depending on the industry and products or services which are sold.