A leverage ratio is one of several financial measurements that glances at how much capital comes in the form of debt (loans) or weighs the capacity of a company to meet its financial obligations.
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How is the Leverage Ratio used in Businesses?
It’s never a good idea to have too much debt in business nor will those investing in such a business look favourably upon such a notion for obvious reasons. But if a business manages to generate a higher return far outweighing the interest rate of the loans used to fund its growth, then it’s a different scenario altogether. At the same, little to know debts can also raise questions on the operational capabilities of the business as it signals that the operating margins are tight or stagnating.
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There are several different ratios that may be categorized as a leverage ratio, but the main factors considered are debt, equity, assets, and interest expenses.
A leverage ratio may also be used to measure a company’s mix of operating expenses to get an idea of how changes in output will affect operating income. Fixed and variable costs are the two types of operating costs; depending on the company and the industry, the mix will differ.
Finally, the consumer leverage ratio refers to the level of consumer debt compared to disposable income and is used in economic analysis and by policymakers.
What are the types of Leverage Ratio?
There are several different leverage ratios that may be considered by market analysts, investors, or lenders. Some accounts that are considered to have significant comparability to debt are total assets, total equity, operating expenses, and incomes.
Below are 5 of the most commonly used leverage ratios:
- Debt-to-Assets Ratio = Total Debt / Total Assets
- Debt-to-Equity Ratio = Total Debt / Total Equity
- Debt-to-Capital Ratio = Today Debt / (Total Debt + Total Equity)
- Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)
- Asset-to-Equity Ratio = Total Assets / Total Equity.
Relevant questions about Leverage Ratio
What is the ideal Leverage Ratio?
A figure of 0.5 or less is ideal. In other words, no more than half of the company’s assets should be financed by debt. In other words, a debt ratio of 0.5 will necessarily mean a debt-to-equity ratio of 1. In both cases, a lower number indicates a company is less dependent on borrowing for its operations.
Why is a high Leverage Ratio considered less than ideal for businesses?
A high leverage ratio indicates a company, bank, home or other institution is largely financed by debt. A high leverage ratio also increases the risk of insolvency. In other words, it becomes more difficult to meet financial obligations when a highly-levered company’s assets suddenly drop in value.
Leverage Ratio – UPSC Notes:- Download PDF Here
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