Leverage is the ratio of a business' debt to its equity. If this ratio is high, the business is putting itself at risk. In the financial world, this ratio is known as the leverage factor. Using the leverage ratio properly will ensure that a business is protected against these risks.
Today’s article is all about understanding the importance of leverage ratio and various formulae for the same, and you’ll also cherish some examples.
Did You Know?
The type of insurance that a company underwrites will determine the ideal gross leverage ratio. The ideal range is usually below 7.0 for liability insurance and below 5.0 for property insurance. Because the gross leverage ratio also includes ceded insurance leverage, an insurer's net leverage will be greater than its gross leverage.
Leverage Ratio Meaning and Formula
Let’s start with knowing what are leverage ratios. The leverage ratio formula is a basic calculation used by financial institutions and investors to assess the efficiency of a company's operations.
- When the ratio exceeds 2.0, the company is likely to risk investors.
- This ratio measures the relationship between the owner's capital and the company's amount of its debts.
- A high D/E ratio indicates a healthy balance between cash and debt, and a low D/E ratio suggests a company that may be too risky for investment.
- It is a good guide to a company's finances, but the formula is limited because it looks at individual areas of the company.
- A leverage ratio formula is a useful tool in risk analysis, particularly for companies with significant debts.
- To determine the correct ratio for your company, you need to compare it with similar companies in your industry. However, you may want to compare your company's debt to equity ratio to ensure that it is within industry standards.
A high leverage ratio indicates a company has a heavy burden on its debt, blocking cash flows that could be used to invest in capital expenditure and other important ways to expand it. Ideally, the ratio will be low, indicating that cash flow can support payments. If a company has a high debt to equity ratio, it may signify that the company is at risk of bankruptcy. Also, learn about accounting ratios for a better understanding of the financial statements of companies.
Also Read: Simple Explanation of Solvency Ratio and its Types
Importance of Leverage Ratio
The importance of the leverage ratio for banks can be easily understood. The ratio is a simple measure of debt against total assets. It should be below three per cent for a bank to be considered healthy.
A high leverage ratio may repel lenders and lead to a lack of capital. Alternatively, a too low ratio could mean a dying business or tight profit margins.
- It can be used to compare companies of the same size and type to see how much they can afford to borrow.
- One important use of the leverage ratio is in analysing a company's financial health.
- In addition, companies use this ratio to boost earnings per share and return on equity. A high ratio can also signal a company taking on too much debt.
- Generally, companies use this metric to determine their debt capacity and ability to withstand negative shocks.
The use of leverage to boost profits is not without risks. However, a highly leveraged firm may struggle with a decline in profitability. Creditors also consider the existing debt level of the company when determining how much money it can borrow.
Leverage adds risk to the equation, but it also rewards when everything works out. In short, it helps companies expand and grow. However, too much leverage could result in bankruptcy.
Types of Leverage Ratio
To understand the leverage ratio examples in the best way, knowing its types is essential. Below, we've covered Capital Structure Ratios and Coverage Rates. Learn about the differences between these ratios and their effect on your business. In addition, you'll learn more about capital structure and how to calculate it for yourself.
Capital Structure Ratio
If your business has a high debt-to-equity ratio, you may have a problem. While this may be an unwelcome fact, it can make it even worse.
Debt-to-equity ratios can be useful for comparing companies with different capital structures. Companies with a lower level of debt will generally be seen as less of a risk.
In contrast, companies with high debt-to-equity ratios may have too much debt, underutilised growth opportunities and overpay for the cost of capital.
Highlights of Capital Structure Ratio
- The capital structure ratio helps you gauge the likelihood of recovery if the organisation does go bankrupt.
- Too much debt can make an otherwise healthy company go bankrupt, and the interest payments incurred will overwhelm its resources.
- The debt-to-equity ratio tells you the proportion of outsiders' claims against the firm's assets. A high ratio indicates that the outsiders' claims are greater than the owner's, making the company more vulnerable to creditors.
- While there is no magic ratio for the perfect capital structure, investors can monitor it and make informed decisions based on it.
- A high capital structure ratio means that investors will be more likely to demand management participation to prevent the company from going bankrupt. A high ratio also means that the business will have to pay more interest on its liabilities in order to maintain a good credit rating.
- The optimal ratio for any company will depend on its industry, stage of development and external changes to interest rates and regulations.
Classification of Capital Structure Ratio
Equity Ratio
The equity ratio is a measure of the leverage a company uses. The equity ratio is calculated by comparing total assets and equity. The high result means that the management has reduced the amount of debt used to finance its assets. This is a prudent way to run an entity.
A low ratio means that the assets were paid for with a lot of debt. In such a case, the management uses leverage to increase an organisation's return on assets (ROI). This is the total ownership contribution to the company.
Formula: Shareholder Equity ÷ Total Capital Employed
Shareholders Equity = Reserve and Surplus Equity share capital
Total Capital Employed = Debentures Shareholders Equity Long-Term Loan
Debt Ratio
The debt ratio can be defined as the ratio between total debt and total assets. It can be expressed as either a percentage or decimal. This ratio can be defined as the percentage of assets owned by a company that is financed with debt. If the ratio is greater than 1, it means that assets finance a large portion of the company's debt.
This indicates that the company has more assets than liabilities. If interest rates rise suddenly, a high ratio could indicate that a company is at risk of defaulting on its loans. A ratio of less than 1 indicates that equity funds make up a larger portion of the company's assets. This is the total leverage in the company.
Formula: Total Debt ÷ Total Capital Employed
Total Debt= Short/Long Term Borrowings, Bonds and Debentures
Debt to Equity Ratio
Investors can use the D/E ratio to determine how a company is performing in terms of capital structure and overall solvent. Investors need to understand the company's strategy before they decide to invest.
If the total liabilities exceed the shareholders' equity, an investor will think twice about whether or not to invest in the company. Too much debt can be too risky.
A higher ratio is more insecure for creditors and other lenders, while a lower ratio means that lenders have more protection.
Formula: Total Debt ÷ Shareholders Fund
Also Read: Definition of Liquidity Ratio and Formula With Examples
Coverage Ratio
The Coverage Ratio, also known as the Interest Earnings Coverage Ratio, is a financial metric that helps companies determine their ability to honour debt payments. The Coverage Ratio is important to understand because many different factors influence it.
Highlights of Coverage Structure Ratio
- A company's coverage ratio measures its ability to pay off its debt and other liabilities. A high ratio means a company can meet its debt obligations; a low value shows a company is unlikely to meet its obligations.
- This ratio may be calculated as EBIT divided by the total interest expense. Here's an example of how the Coverage Ratio is calculated. The higher the Coverage Ratio, the better. But remember, this measure is not completely accurate.
- A low value does not necessarily mean a company has less capacity, as other factors may also play. Investors may use three different coverage ratios to evaluate their ability to repay their debt.
- With a high Coverage Ratio, a business has a better cushion for unexpected downturns. On the other hand, a company with a low Coverage Ratio could fail if it suffers a temporary economic downturn.
- Generally, a company's EBIT (earnings before interest and taxes) must cover its total interest expenses, including debt.
- A lower Coverage Ratio could mean that a company is not prepared to meet its financial obligations and could be at risk of bankruptcy.
Conclusion
So, that was all about leverage ratio and its further classifications. The understanding of leverage ratio and its types is vital for an accountant to avoid wrong or risky investments for the company/individual. Now keep track of your cashflow and manage your incomes and expenses with ease by using the Cashbook app by Khatabook.
