As your business grows, it needs more money to sustain itself in both equity and debt. 

Leverage ratios help lenders, investors and shareholders assess the ability of a business to pay back. The return on investment must be greater than any interest owed on debts in order for it to be profitable and provide healthy dividends to shareholders.

Leverage ratios use calculations from your company’s balance sheet, income statement or cash flow statement to estimate the long-term financial health of your company.  These ratios provide a picture of your company’s assets, debt load and ability to pay back financial obligations. 

Why Leverage Ratios Matter

Leverage ratios are often used by lenders and investors to determine the amount of risk involved with a particular investment or loan. 

The lower the ratio, the easier it is for your company to secure loans and investments.

There are several different types of leverage ratios. In order for a company to be sustainable in the long term, these ratios must be balanced.

The higher your company’s financial risk, the more likely you are to receive less favorable loan terms from lenders. If your ratios are too high, you may be denied loans or capital investments altogether. 

Leverage ratios also help your company create pro forma financial statements. These statements serve a variety of purposes, including:

  • Obtaining financing
  • Forecasting merger and acquisition outcomes
  • Budget preparation
  • Showing future profits after a company restructure

Leverage Ratio Types and How They’re Calculated

There are many different types of leverage ratios. According to Investing Answers, the two most common are the debt ratio and the debt-to-equity ratio. 

Debt and debt-to-equity ratios help lenders and investors determine how easy it is for a company to pay back financial obligations if interest rates increase or profits temporarily decrease. This type of risk assessment is critical to your ability to obtain financing and investments.

Here are the five main types of leverage ratios and the formulas for calculating each one:

1. Debt Ratio

Your company’s debt ratio shows how much of your company’s assets (like real estate or property) is financed. This is also referred to as the debt-to-assets ratio. If your debt ratio is greater than 1, this means your company has more liabilities than it does assets. This puts your company in a high financial risk category. It would be difficult to acquire financing.

Formula: Total Debt / Total Assets

2. Debt-Equity Ratio

The debt-equity ratio is a calculation to look at how company liabilities stack up against company equity. Unlike the debt ratio which looks at all assets, a debt-equity ratio uses total equity in the formula below. This ratio helps a lender determine if a company is financing operations with mostly debt or equity.

Formula: Total Debt / Total Equity

3. Debt-to-Capital Ratio

Debt-to-capital ratios are often used by investors to determine risk when investing in a company. These ratios are calculated by dividing a company’s total debt up to the time of calculation by a company’s total capital. Total capital is all the company’s financial obligations plus the total amount of shareholder’s equity.

Formula: Debt to Date / (Total Debt + Total Equity)

4. Debt-to-EBITDA Ratio

Earnings before interest, taxes, depreciation and amortization (EBITDA) allows companies to get a clear picture of their cash flow. The debt-to-EBITDA ratio provides a good picture of your company’s overall financial health. It provides a snapshot of your company’s debts divided by its cash flow. If the ratio is low, this means it is easy for your company to pay bills on time.

Formula: Total Debt / EBITDA

5. Asset-to-Equity Ratio

Your company’s asset-to-equity ratio is the number of total assets funded by company shareholders. Shareholder’s equity can be in the form of minority interest, common stock or preferred stock. 

When asset-to-equity ratios are low, that means your company has chosen conservative financing with a minimal amount to debt. If these ratios are high, it often means debt is high and lenders are unlikely to provide additional financing.

Formula: Total Assets / Total Equity

Types of Leverage

Leverage is a business finance term that refers to the way your company buys assets, increases cashflows and returns. 

There are three types of leverage:  

  • Operating Leverage
  • Financial Leverage
  • Combined Leverage

Let’s take a closer look at these strategies, as well as the pros and cons of each one.

1. Operating

If your company’s operating leverage is high, that means your operating expenses are relatively low. This means an increase in revenue is going to have a greater effect on your bottom line than a similar company with higher operating expenses.

Here’s an example formula using two fictional companies that make it easy to see which company has the best operating leverage:

Company A

Revenue for one e-commerce product = $1,000

Cost of Goods Sold = $200

Gross Profit = $800

Operating Expenses = $300

Operating Profit = $500

Interest Expense = $50

Earnings Before Taxes = $450

Tax Expense = $250

Net Income = $200

 

Company B

Revenue for one e-commerce product = $1,000

Cost of Goods Sold = $200

Gross Profit = $800

Operating Expenses = $200

Operating Profit = $600

Interest Expense = $50

Earnings Before Taxes = $550

Tax Expense = $250

Net Income = $300

The net income of the two companies differs because of the change in the operating expenses. Company A had higher operating expenses, so they have lower operating leverage.

2. Financial

Financial leverage is a strategy where your company uses debt to acquire assets. It is also called trading on equity. When you get financing, you have much more buying power and can purchase equipment or real estate that may be impossible for you to do with other types of leverage.

Here is another example to demonstrate the power of financial leverage on its own:

Your company needs to move to a larger facility. You prefer to purchase property rather than lease because of long-term financial gains. You find a building and property suitable for your current needs that also provides adequate space for future growth. 

Down Payment = $1,000,000

Debt = $4,000,000

Property Cost (Building + Land) = $5,000,000

(Do not include in calculations Cost of Debt = $500,000)

Resale Price = $6,000,000

Cost to You to Payoff Debt = $4,500,000

Profit to You = $1,500,000

By using financial leverage, your company was able to profit $1,500,000 after selling the property 10 years later.

3. Combined

In general, leverage addresses both the financial risk and potential returns for a company. Though companies often rely more on one type of leverage over another, a combined approach is often beneficial. The advantages of using a combined method of leverage are best as your company begins to grow.

Using the Right Leverage Ratio 

Here are the two main benefits to each of the above types of leverage:

  • Operational leverage is beneficial to service-based companies that can get by with a smaller amount of debt.
  • Financial leverage is beneficial to companies that buy large assets (like real estate). These assets will substantially increase returns immediately or in the long-term.

When using a combined approach to leverage, it is best to determine what the appropriate type of leverage is before using it. Operational leverage is best if you are selling a low-cost product and the profits are derived from labor. Use financial leverage when you are looking to invest in a substantial amount of inventory, equipment or a large piece of real estate. 

Wrapping It Up

Leverage ratios are an important part of understanding your company’s capital structure and obtaining financing. But ratios are only part of the equation. Understanding the concept of leverage is critical to knowing when to apply for a loan in the first place.

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