LEVERAGE RATIO: WHAT IT IS, HOW IT IS CALCULATED AND EXAMPLES - DUDAS - 2025

The leverage ratio is an indicator that assesses how much of a company's capital comes from debt, indicating how risky a company is from the perspective of its use of debt relative to its assets.

The leverage ratio of a company indicates how much of its assets is repaid with borrowed money. When the ratio is high, it means that most of the company's assets are repaid with debt.

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In general terms, companies want this ratio to fall between 0.1 and 1.0. A ratio of 0.1 indicates that a business has almost no debt to assets, and a ratio of 1.0 indicates that a business has as much debt as assets.

A ratio of 0.5 is more common, indicating that a company has twice as many assets as it has debt. The highest ratios are common among startups just starting out or companies with high production costs.

What is the leverage ratio?

If you're running a start-up, chances are you're trying to get financing from a venture capital firm or bank.

If you are trying to raise funds, it is important that financial records are in order so that investors can assess whether the business will be a risky or valuable investment.

One of the indicators that could be used to judge the health of the business is financial leverage, which can be measured quantitatively with the leverage ratio.

The leverage ratio measures how leveraged a company is. The degree of leverage or debt load of a company is a measure of risk.

A high leverage ratio indicates that a company is using debt to finance its assets and operations, compared to a company with a lower leverage ratio.

This shows that even though the business is in debt, its operations and sales generate enough income to grow its assets through profits.

Interest paid on debt may be tax deductible and allows the company to take advantage of opportunities that it could not otherwise afford.

Leverage ratio analysis

When the leverage ratio is high, the company has a large amount of debt relative to its assets.

Therefore, this carries a higher burden in the sense that principal and interest payments take a significant amount of the company's cash flows. Any failure in financial performance or an increase in interest rates could result in default.

When the leverage ratio is low, principal and interest payments do not require as large a portion of the company's cash flow, and the business is not as sensitive to changes in business or interest rates from this perspective.

However, a low leverage ratio may also indicate that the company is not taking advantage of the increased profitability that financial leverage can bring. On many occasions, you have the opportunity to use leverage as a means to grow your business responsibly.

Importance

Lenders and investors generally prefer low leverage ratios, because the interests of the former are better protected in the event of a business decline and shareholders are more likely to receive at least part of their original investment in the event of a liquidation.

In general, for this reason, high leverage ratios can prevent a company from attracting additional capital.

It is important to note that the timing of asset purchases and differences in debt structure can lead to different leverage ratios for similar companies.

This is the reason why the leverage ratio comparison is generally more revealing between companies within the same industry. The definition of a "low" or "high" ratio must be made within this context.

How is it calculated?

A leverage ratio is simply the total debt of a company divided by its total assets. The formula is as follows:

Leverage ratio = total debt / total assets.

The formula for the leverage ratio is basically used to measure the level of debt of a company in relation to the size of the balance sheet.

The calculation of the leverage ratio is mainly done by comparing the total debt obligation in relation to the total assets of the companies.

A high leverage ratio indicates that the company may have taken out too many loans and is too indebted compared to the company's ability to reasonably repay the debt with future cash flows.

The formula for the leverage ratio can be calculated using the following steps.

Step 1

First, total debt, which includes both short-term financing and long-term financing, and total assets, which are readily available on the company's balance sheet, are calculated.

Step 2

Next, the leverage ratio is calculated by dividing total debt by total assets.

Examples

A leverage ratio of 2 to 1 means that for every $ 1 of assets, the company has $ 2 in debt. High debt can hinder a business's cash flow due to large interest payments and limit its ability to borrow more money.

XYZ Company

If Company XYZ had on its balance sheet a total of $ 10 million of debt and $ 15 million of assets, then Company XYZ's leverage ratio will be:

Leverage ratio = $ 10,000,000 / $ 15,000,000 = 0.67 or 67%.

This means that for every dollar of assets that Company XYZ has, Company XYZ had $ 0.67 of debt. A ratio above 1.0 would indicate that the company has more debt than assets.

ABC Company

Let's assume that Company ABC has the following financial data on its balance sheet for the current year:

From the data in this balance sheet, the corresponding leverage ratio can be calculated:

Total debt = short-term bank loan + long-term bank loan. Therefore, the total debt is equal to: $ 12,000 + $ 24,000 = $ 36,000.

According to the table, the total assets are $ 75,000. Applying the formula for the leverage ratio, the following result is obtained: $ 36,000 / $ 75,000 = 0.48.

References

1. Sophia Bernazzani (2019). Leverage Ratio: What It Means and How to Calculate It. Taken from: blog.hubspot.com.
2. Investing Answers (2019). Leverage Ratio. Taken from: investinganswers.com.
3. Wall Street Mojo (2019). Leverage Ratios Formula. Taken from: wallstreetmojo.com.
4. Mark Kennan (2019). How to Calculate Leverage Ratio. The Nest. Taken from: budgeting.thenest.com.
5. Cleartax (2019). Leverage Ratio with Formula and Examples. Taken from: cleartax.in.