Leverage Ratios Definition
Leverage ratios are financial ratios that specify the level of debt incurred by a business relative to other accounting heads on its balance sheet. For example, the debt-to-equity ratio is a leverage ratio that displays the total amount of debt for a business in relation to its stockholder equity. While they were originally designed to evaluate companies in the stock market, leverage ratios have become important tools after the 2008 financial crisis to prevent systemically-important financial institutions from defaulting or going bankrupt. Leverage ratios are different from liquidity ratios, which are primarily used to measure the amount of liquidity available to a company to fund their operations and their debt obligations.
Using Leverage Ratios in Analysis
Primarily, leverage ratios are used for two purposes:
- They are indicators of a company’s ability to meet its short-term and long-term debt obligations. Debt generally gets a bad rep but it has its advantages. For example, interest payments on certain kinds of debt are tax-deductible and can reduce the overall amount of debt that a company incurs. A leverage ratio greater than 1 indicates that the company is operating with significant amounts of debt and may not be able to service its future payments on that debt.
- They are used to evaluate a company’s capital structure. For example, the Debt-to-Assets ratio is an indicator of the company’s debt relative to its assets. Similarly, the Assets-to-Equity ratio can be used to measure its assets versus stockholder equity. Together, both ratios provide a window into the company’s spending and debt allocations.
Leverage ratios are not set in stone and can vary between industries and sectors. In an industry with relatively few competitors and high profits, high leverage ratios or debt loads are acceptable for companies operating in that industry. But the same analysis does not hold true for industries in which there are many competitors and profit margins are thin. A small or mid-sized outfit operating in such an industry may not be able to pay back debt, even if it generates profits because its success depends on manufacturing volume. As such, any analysis using leverage ratios should take into consideration the specifics of an industry and market.
Measuring Leverage Ratios
Generally, a company’s debt is measured against five accounts: total assets, total equity, total operating expenses, and total income. As such, common leverage ratios are measured against these parameters.
The five most-used leverage ratios are:
- Debt-to-Assets Ratio, which measures a company’s ability to service its debt obligations with respect to its tangible and intangible assets and is calculated as Total Debt/Total Assets.
- Debt-to-Equity Ratio, which measures a company’s ability to service its debt obligations with respect to shareholder equity is calculated as Total Debt/Total Equity.
- Debt-to-Capital Ratio, which measures a company’s ability to service its debt obligations with respect to capital, including shareholder equity and interest-bearing debt, calculated as Total Debt/ (Total Debt + Total Equity).
- Debt-to-EBITDA Ratio, which measures a company’s ability to service its debt obligations with respect to its earnings and is calculated as Total Debt/Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA).
- Asset-to-Equity Ratio, which measures the stability of a company’s finances by dividing its total assets with its total equity and is calculated as Total Assets/Total Equity.
Leverage ratios are generally assigned scores starting from 0.1. A leverage ratio of 1 means the company has equal amounts of debt and the other, comparable metric being measured.
A leverage ratio greater than 1 may not be a good sign because it means that the company has high levels of debt and not enough assets or earnings to make payments for that debt. For example, a leverage ratio of 2:1 means that the company owes $2 for every $1 invested in it.
A score of 1 is the ideal leverage ratio for companies but some industries have ratios greater than 1 due to the nature of their operations. For example, companies in the manufacturing and retail sector have leverage ratios much greater than 1 because they have high inventory numbers, which are included in debt calculations, to operate efficiently. As such, it is always better to compare leverage ratios between companies in a particular industry instead of comparing them across industries.
Tier 1 Leverage Ratio
After the financial crisis of 2008, a new leverage ratio to measure the capital adequacy of financial institutions in the event of a crisis was introduced by the Basel Committee on Banking Supervision in 2009. This leverage ratio is known as the Tier 1 leverage ratio and measures the total amount of Tier 1 Capital available to a bank in relation to other assets. Tier 1 Capital consists of the most liquid assets available to a bank in case of a financial crisis. For example, Treasury Bonds are considered part of Tier 1 Capital because they can be liquidated easily and there is a ready market available for them.
The formula to calculate Tier 1 Leverage Ratio is:
Tier 1 Leverage Ratio = Tier 1 Capital/Consolidated Assets X 100
Under Basel III regulations, systemically-important financial institutions should have a minimum leverage ratio of 6% to ensure that they are able to survive a financial crisis.