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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Leverage Ratio

What it is:

A leverage ratio is meant to evaluate a company’s debt levels. The most common leverage ratios are the debt ratio and the debt-to-equity ratio.

How it works (Example):

A debt ratio is simply a company's total debt divided by its total assets. The formula is:

Debt Ratio = Total Debt / Total Assets

For example, if Company XYZ had $10 million of debt on its balance sheet and $15 million of assets, then Company XYZ's debt ratio is:

Debt Ratio = $10,000,000 / $15,000,000 = 0.67 or 67%

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

The debt-to-equity ratio is a measure of the relationship between the capital contributed by creditors and the capital contributed by owners. It also shows the extent to which shareholders' equity can fulfill a company's obligations to creditors in the event of a liquidation.

Here is the formula for the debt-to-equity ratio:

Debt-to-Equity Ratio = Total Debt/Total Equity

For example, if Company XYZ had $10 million of debt on its balance sheet and $10 million of total equity, then Company XYZ's debt ratio is:

Debt-to-Equity Ratio = $10,000,000/$10,000,000 = 1.0 times or 100%

This means that for every dollar of Company XYZ owned by the shareholders, Company XYZ owes $1 to creditors.

It is important to note that there are many ways to calculate the debt-to-equity ratio, and therefore it is important to be clear about what types of debt and equity are being used when comparing debt-to-equity ratios. There is also some debate over whether the book value or the market value of a company's debt and equity should be used when calculating a company's debt-to-equity ratio.

Why it Matters:

Leverage ratios measure how leveraged a company is, and a company's degree of leverage (that is, its debt load) is often a measure of risk. When the debt ratio is high, for example, the company has a lot of debt relative to its assets. It is thus carrying a bigger burden in the sense that principal and interest payments take a significant amount of the company's cash flows, and a hiccup in financial performance or a rise in interest rates could result in default. When the debt ratio is low, principal and interest payments don't command such a large portion of the company's cash flow and the company is not as sensitive to changes in business or interest rates from this perspective. However, a low debt ratio may also indicate that the company has an opportunity to use leverage as a means of responsibly growing the business.

In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, low debt-to-equity ratios may also indicate that a company is not taking advantage of the increased profits that financial leverage may bring.

It is important to note that the timing of asset purchases and differences in debt structures can generate differing debt ratios for similar companies. This is why comparison of debt ratios is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.

Lenders and investors usually prefer low leverage ratios because the lenders' interests are better protected in the event of a business decline and the shareholders are more likely to receive at least some of their original investment back in the event of a liquidation. This is generally why high leverage ratios may prevent a company from attracting additional capital.