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Leverage Ratios

Salem_MA_66383_n
(Salem, Massachusetts - ROC (Taiwan) Student Association of MIT)

 

A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet its financial obligations. The leverage ratio is important given that companies rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due.

Too much debt can be dangerous for a company and its investors. However, if a company's operations can generate a higher rate of return than the interest rate on its loans, then the debt is helping to fuel growth in profits. Nonetheless, uncontrolled debt levels can lead to credit downgrades or worse. On the other hand, too few debt can also raise questions. A reluctance or inability to borrow may be a sign that operating margins are simply too tight.

There are several different specific 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 as compared to disposable income and is used in economic analysis and by policymakers.

The most well known financial leverage ratio is the debt-to-equity ratio. It is expressed as: D/E Ratio = Total Debt / Total Equity   

 

Two Main Leverage Ratios

 
"Leverage ratios are used to determine the relative level of debt load that a business has incurred. These ratios compare the total debt obligation to either the assets or equity of a business. A high ratio indicates that a business may have incurred a higher level of debt than it can be reasonably expected to service with ongoing cash flows.

The two main leverage ratios are:

  • Debt ratio. Compares assets to debt, and is calculated as total debt divided by total assets. A high ratio indicates that the bulk of asset purchases are being funded with debt.
  • Debt to equity ratio. Compares equity to debt, and is calculated as total debt divided by total equity. A high ratio indicates that the business owners may not be providing sufficient equity to fund a business.

Leverage ratios are essentially measures of risk, since a borrower that cannot pay back its debt obligations is at considerable risk of entering bankruptcy protection. However, a modest amount of leverage can be beneficial to shareholders, since it means that a business is minimizing its use of equity to fund operations, which increases the return on equity for existing shareholders.

A prospective lender may use leverage ratios as part of its analysis of whether to lend funds to a business. However, these ratios do not provide sufficient information for a lending decision. A lender also needs to know if a business is generating sufficient cash flows to pay back debt, which involves a review of both the income statement and
statement of cash flows. A lender will also review a company's budget, to see if projected cash flows can continue to support ongoing debt payments.

In addition, the nature of the industry in which a business is located plays a significant role in the lending decision. For example, if an industry has few competitors, there are high barriers to entry, and there is a long history of above-average profits, then an organization could probably maintain a high debt load over a long period of time. Conversely, in an industry where market share changes continually, product cycles are short, and capital investment requirements are high, it is quite difficult to have stable cash flows - and lenders
will be less inclined to lend money.

In short, leverage ratios are used for a portion of the analysis when determining whether to lend money, but a great deal of additional information is needed before a lending decision can be made." -- (Accounting Tools)

 

 

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