Financial leverage ratios and formula
Financial leverage ratios assess the value of a company’s equity by examining its overall debt image. These ratios compare debt or equity to assets as well as shares outstanding to determine the true value of a business’s equity.
In this article, we will explain what financial leverage ratios are, state the financial leverage ratio formulas and give some examples of how to calculate this financial metric using their various formulas.
What are financial leverage ratios?
In other words, financial leverage ratios assess a company’s overall debt load and compare it to its assets or equity. This demonstrates how much of the company’s assets are owned by shareholders rather than creditors. When the majority of the assets are owned by shareholders, the company is said to be less financially leveraged. On the other hand, when creditors own the majority of the company’s assets, the company is said to be highly financially leveraged. All of these metrics are important for investors to understand how risky a company’s capital structure is and whether it is worth investing in.
Financial leverage ratios
- Debt-to-asset ratio
- Debt-to-equity ratio
- Debt ratio
- Earnings per share
- Equity multiplier
- Return of equity (ROE)
- Return on assets (ROA)
- Debt-to-EBITDA ratio
A variety of financial leverage ratio formulas are used to calculate the amount of debt a company is leveraging in order to increase its profits. Several financial leverage ratios are listed above and will be explained in more detail.
Debt-to-asset ratio
The debt to asset ratio is a financial leverage ratio that calculates the percentage of total assets financed by creditors rather than investors. In other words, it shows the percentage of assets funded by borrowing versus the percentage of resources funded by investors.
Essentially, it depicts how a company has grown and acquired assets over time. Companies can generate investor interest in order to obtain capital, generate profits in order to acquire their own assets, or incur debt. Obviously, the first two are preferred in the majority of cases.
This is an important metric because it shows how leveraged the company is by examining how much of the company’s resources are owned by shareholders as equity and creditors as debt. This figure is used by both investors and creditors to make business decisions.
In corporate finance, investors want to know if a company is solvent, that is, has enough cash to meet its current obligations, and is profitable enough to pay a return on investment. While creditors want to know how much debt the company already has because they are concerned about collateral and repayment ability. If the company has already leveraged all of its assets and is struggling to meet its monthly payments, the lender is unlikely to extend any additional credit.
The formula for debt-to-asset ratio as a financial leverage ratio
This ratio is calculated by dividing total liabilities or debt by total assets.
This equation is quite straightforward, as you can see. Total debt is calculated as a percentage of all assets. This formula can be modified to only include particular assets or liabilities, such as the current ratio. However, this financial comparison is a broad assessment meant to gauge the performance of the company as a whole.
Interpretation of debt to asset ratio (DTA)
This measurement is used by analysts, investors, and creditors to assess a company’s overall risk. Due to their higher leverage, companies with higher figures are viewed as riskier to lend to and invest in. This implies that compared to a company of equal size with a lower ratio, a company with a higher measurement will be required to fork over a larger portion of its profits as principal and interest payments. Lower is thus always preferable.
When the ratio of debt to assets is 1, the company’s liabilities and assets are equal. The company has a high level of leverage when a company’s DTA is higher than 1, which means that it has more liabilities than assets. Investments in or loans to this company are extremely risky due to its high level of leverage. A company with a DTA of less than 1 demonstrates that it has more assets than liabilities and, if necessary, could settle its debts through the sale of its assets.
Example of debt to asset ratio (DTA)
Fred’s Body Shop is an Atlanta-area auto repair shop. He’s looking for a loan to help him build a new facility with more lifts. Fred currently has $100,000 in assets and $50,000 in liabilities. His DTA would be calculated as follows:
Debt to asset ratio = 50,000 / 100,000
DTA = 0.5
Fred’s DTA is 0.5 because he has twice as many assets as liabilities. This would be taken into account by Fred’s bank during the loan application process.
Fred’s 0.5 DTA is useful for determining his leverage, but it is somewhat meaningless without something to compare it to. For example, if his industry had an average DTA of 1.25, you’d think Fred’s doing a fantastic job. If the industry standard was 10%, the opposite would be true. It’s always a good idea to compare this calculation to others in the industry.
Debt-to-equity ratio
The debt-to-equity ratio is a liquidity and financial metric that contrasts a company’s total debt and equity. The ratio of debt to equity reveals how much of a company’s funding comes from creditors and investors. A higher debt-to-equity ratio indicates that bank loans are used as opposed to investor financing more frequently (shareholders).
The formula for debt-to-equity ratio as a financial leverage ratio
The debt to equity ratio is determined or calculated by dividing the total liabilities by total equity. Mathematically, this formula can be represented as:
Debt to equity ratio = Total liabilities / Total equity
Interpretation of debt to equity ratio
Because some industries use more debt financing than others, each industry has its own debt-to-equity ratio benchmark. A debt ratio of 0.5 indicates that there are half as many liabilities as there are assets. In other words, the company’s assets are funded 2-to-1 by investors versus creditors. This means that investors own 66.6 cents on the dollar of company assets, while creditors own only 33.3 cents.
The debt to equity ratio of one indicates that both investors and creditors have an equal stake in the company’s assets. On the other hand, a lower debt-to-equity ratio typically indicates a more financially stable company. Companies with a higher debt-to-equity ratio are viewed as riskier by creditors and investors than those with a lower ratio.
A higher debt to equity ratio is viewed as risky by creditors because it indicates that investors have not funded the operations as much as creditors have. In other words, investors do not have the same stake in the game as creditors. This could imply that investors are unwilling to fund business operations because the company is underperforming. Inadequate performance could also be the reason the company is seeking additional debt financing.
Example
Assume a business has $100,000 in bank credit and a $500,000 mortgage on its property. The company’s shareholders have contributed $1.2 million. What is the debt to equity ratio of the business?
Solution
Here’s how to figure out your debt-to-equity ratio.
Using the formula of debt to equity ratio:
Debt to equity ratio = Total liabilities / Total equity
Where; Total liabilities = 100,000 + 500,000 = 600,000 and total equity =1,200,000
Therefore;
Debt to equity ratio = 600,000 / 1,200,000
Debt to equity ratio = 0.5
In this business, there are half as many liabilities as there are assets with a debt ratio of 0.5. In other words, investors fund the company’s assets two to one over creditors.
Debt ratio
The debt ratio is a measure of a company’s solvency that compares all of its liabilities to all of its assets. The debt ratio essentially demonstrates a company’s capacity to cover its liabilities with its assets. In other words, this demonstrates how many assets must be sold by the business in order to cover all of its debts.
This ratio calculates a company’s level of financial leverage. Companies that have more liabilities than assets are thought to be highly leveraged and pose a greater risk to lenders.
This aids creditors and investors in analyzing the total amount of debt owed by the business as well as its capacity to service that debt in the event of future, unstable economic conditions.
The formula for debt ratio
The formula for debt ratio is given as dividing total liabilities by total assets. Mathematically it can be written as:
Debt ratio = Total liabilities / Total Assets
Because this financial leverage ratio formula calculates total liabilities as a percentage of total assets, the debt ratio is displayed in decimal format. In your calculation, make sure to include both total liabilities and total assets. The debt ratio displays the company’s total debt burden, not just the current debt.
Interpretation of debt ratio
As with many solvency ratios, lower ratios are preferable to higher ratios. Hence, a lower debt ratio usually indicates a more stable business with the potential for longevity, because a lower ratio also implies a lower overall debt. Each industry has its own debt benchmark, but 0.5 is a reasonable ratio.
A debt ratio of 0.5 is frequently regarded as less risky. This means that the company’s assets outnumber its liabilities by a factor of two. In other words, this company’s liabilities are only half of its total assets. In essence, only its creditors own half of the company’s assets, while the remaining assets are owned by the shareholders.
Total liabilities equal total assets in a ratio of one. In other words, in order to pay off its liabilities, the company would have to sell all of its assets. This is clearly a high-leverage firm. The company can no longer operate once its assets have been sold.
Because creditors are always concerned about being repaid, the debt ratio is a fundamental solvency ratio. When companies borrow more money, their debt-to-equity ratio rises, and creditors refuse to lend them money. Companies with higher debt ratios should seek equity financing to expand their operations.
Example of debt ratio
Ed’s Guitar Shop is considering adding a storage addition to the back of its current building. Ed consults with his banker about applying for a new loan. The bank requests Ed’s balance in order to examine his overall debt levels. The banker discovers that Ed has $100,000 in assets and $25,000 in liabilities. Calculate the debt ratio.
Solution
Ed’s debt ratio would be calculated as follows:
Debt ratio = Total liabilities / Total Assets
Debt ratio = 25,000 / 100,000
Debt ratio = 0.25
Ed only has a debt-to-income ratio of 0.25. In other words, Ed’s assets are four times greater than his liabilities. The fact that this ratio is so low suggests that Ed will be able to repay his loan. Ed shouldn’t have any trouble getting his loan approved.
Earnings per share (EPS)
Earnings per share (EPS), also known as net income per share, is a market prospect ratio that calculates the amount of net income earned per outstanding share of stock. In other words, this is the amount of money that each share of stock would receive if all profits were distributed at the end of the year to all outstanding shares.
Earnings per share is another calculation that indicates how profitable a company is on a per-share basis. Profits per share of a larger company can thus be compared to profits per share of a smaller company. This calculation is obviously heavily influenced by the number of outstanding shares. As a result, a larger company must distribute its profits across many more shares of stock than a smaller company.
The formula for earnings per share
Earnings per share are calculated by deducting preferred dividends from net income and dividing by the weighted average number of common shares outstanding. The formula can be written mathematically as:
Earnings per share = Net income – preferred dividends / Weighted average number of common shares outstanding
In the financial leverage ratio formula used in the earnings per share calculation, preferred dividends are subtracted from net income. This is due to the fact that EPS only measures income available to common stockholders. Preferred dividends are reserved for preferred shareholders and cannot be distributed to common shareholders.
Earnings per share are typically calculated for year-end financial statements. Because companies frequently issue new stock and buy back treasury stock throughout the year, the calculation uses the weighted average common shares. By adding the beginning and ending outstanding shares and dividing them by two, the weighted average common shares outstanding can be calculated.
Interpretation of earnings per share as a financial leverage ratio
Earnings per share are equivalent to any profitability or market prospect ratio. A higher ratio is always preferable to a lower ratio because it indicates that the company is more profitable and has more profits to distribute to its shareholders.
Although many investors ignore the EPS, higher earnings per share ratio often cause a company’s stock price to rise. Because so many factors can influence this ratio, investors look at it but don’t let it heavily influence their decisions.
Example
Value Co. earned $50,000 in net income last year. There are no preferred shares outstanding because the company is small. During the year, Value Co. had 5,000 weighted average shares outstanding. Calculate the EPS of value Co.
Solution
The EPS of Value is calculated as follows:
Earnings per share = Net income – preferred dividends / Weighted average number of common shares outstanding
EPS = 50,000 – 0 / 5000
EPS = 10
Value’s EPS for the year is $10, as shown. This means that if Value distributed every dollar of its earnings to its shareholders, each share would receive $10.
Equity multiplier
The equity multiplier is a financial leverage ratio that compares total assets to total shareholder’s equity to determine how much of a company’s assets are financed by its shareholders. In other words, the equity multiplier represents the proportion of assets financed or owned by shareholders. In contrast, this ratio demonstrates the amount of debt used to acquire assets and maintain operations.
The equity multiplier, like all liquidity and financial leverage ratios, indicates the company’s risk to creditors. Companies that rely too heavily on debt financing will face high debt service costs and will need to generate more cash flows to cover their operations and obligations. This ratio is used by both creditors and investors to determine how leveraged a company is.
The formula for equity multiplier as a financial leverage ratio
The financial leverage ratio formula for equity multiplier is given as dividing total assets by total stockholder’s equity. The equation can be written as:
Equity multiplier = Total assets / Total stockholder’s equity
Interpretation of equity multiplier
The equity multiplier is a ratio that can be used to evaluate a company’s debt and equity financing strategy. A higher ratio indicates that debt was used to fund more assets than equity. To put it another way, investors funded fewer assets than creditors.
When a company’s assets are primarily funded by debt, the company is deemed highly leveraged and thus more risky for investors and creditors. This also implies that current shareholders own less of the company’s assets than current creditors.
Because businesses with lower ratios rely less on debt financing and don’t have high debt servicing costs, lower multiplier ratios are always viewed as more conservative and favorable than higher ratios.
Example of an equity multiplier
To maintain telephone lines and other telephone cables, Matt’s Telephone Company collaborates with the local utility companies. Matt wants to make sure his equity multiplier ratio is favorable as he plans to take his business public in the next two years. Matt has $900,000 in total equity and $1,000,000 in total assets, according to his financial statements. What is the equity multiplier of matt’s telephone company?
Solution
Matt’s multiplier is determined as follows:
Earnings per share = Net income – preferred dividends / Weighted average number of common shares outstanding
Earnings per share = 1,000,000 / 900,000
Earnings per share = 1.11
You can see Matt’s ratio is 1.11 in this example. This indicates that Matt has very little debt. His assets are only 10% financed by debt. Contrarily, 90% of his assets are financed by investors. As a result, Matt’s business is very cautious when it comes to creditors. However, Matt’s low ratio will have a negative impact on his return on equity.
Return of equity (ROE)
The return on equity ratio, also known as the ROE, is a profitability ratio that assesses a company’s capacity to make a profit from the investments made by its shareholders. In other words, the return on equity ratio displays the amount of profit that is produced for each dollar of equity held by common stockholders.
A return on 1 denotes the amount of net income produced by each dollar of common stockholders’ equity. Potential investors need to know how effectively a company will use its funds to generate net income, so this metric is crucial to them.
The formula for return of equity as a financial leverage ratio
The formula for return of equity is given as:
ROE = Net income / shareholder’s equity
This financial leverage ratio formula is used to calculate for common shareholders. In this calculation, preferred dividends are not taken into account because common stockholders are not eligible to receive these profits. Following that, preferred dividends are subtracted from net income to make the calculation. Additionally, the average of beginning and ending equity is determined because the average common stockholder’s equity is typically used.
Interpretation of return of equity ratio
Return on equity gauges how effectively a business can use shareholder capital to make money and expand. In contrast to other return on investment ratios, ROE measures profitability from the perspective of the investor, not the company. In other words, rather than the company investing in assets or something else, this ratio determines how much money is made based on the investors’ investment in the company.
Having said that, investors want to see a high return on equity ratio because it indicates that the company is making good use of its investors’ money. Higher ratios are almost always better than lower ratios, but they must be compared to the ratios of other companies in the industry. Because each industry has a different level of investors and income, ROE cannot be used to effectively compare companies outside of their industries.
Many investors also choose to calculate the return on equity at the beginning and end of a period to see how the return changes. This aids in tracking a company’s progress and ability to sustain a positive earnings trend.
An average of 5 to 10 years of ROE ratios will provide investors with a more accurate picture of this company’s growth. However, company growth or a higher ROE is not always passed on to investors. If the company keeps these profits, common shareholders will only benefit from them if their stock rises in value.
Example of return of equity ratio as a financial leverage ratio
Tom’s Tool Company is a retail store that sells construction tools to companies all over the country. Tom reported $100,000 in net income and paid $10,000 in preferred dividends during the fiscal year. Tom also had 10,000 common shares with a par value of $5 outstanding during the year. Calculate the ROE of Tom’s tool company.
Solution
Tom would compute his return on common equity as follows:
ROE = Net income / shareholder’s equity
Where; Net income = 100,000 – 10,000 = 90,000 and shareholder’s equity = 10,000 * 5 = 50,000
Therefore,
ROE = 90,000 / 50,000
ROE = 1.8
Tom’s ROE is 1.8 after preferred dividends are deducted from net income. This means that every dollar of common stock earned about $1.80 this year. In other words, investors received a 180 percent return on their investment. Tom’s ratio is likely to be considered high in his industry. This could indicate that Tom’s is expanding.
Return on assets (ROA)
The return on assets ratio, also known as the return on total assets, is a profitability ratio that compares net income to the average total assets to calculate the net income produced by total assets over a given period. In other words, the return on assets ratio (ROA) measures how effectively a company can manage its assets to generate profits over time.
Because the sole purpose of a company’s assets is to generate revenues and profits, this ratio assists both management and investors in determining how well the company can convert its asset investments into profits. Because capital assets are often the largest investment for most businesses, ROA can be viewed as a return on investment for the company. In this case, the company invests money into capital assets and the return is measured in profits. In a nutshell, this ratio assesses the profitability of a company’s assets.
The formula for return on assets (ROA)
The formula for return of assets is given as:
ROE = Net income / Average total assets
This is a financial leverage ratio formula that can also be calculated as a function of the profit margin and total asset turnover.
Interpretation of return of assets ratio as a financial leverage ratio
The return on assets ratio assesses how well a company can earn a return on its asset investment. In other words, ROA demonstrates how effectively a company can convert the money spent on asset acquisition into net income or profits.
Because all assets are either funded by equity or debt, some investors attempt to ignore the costs of acquisition in the return calculation by including interest expense in the formula.
It stands to reason that a higher ratio is more appealing to investors because it demonstrates that the company is more effectively managing its assets to generate higher levels of net income. A positive ROA ratio usually indicates an increasing profit trend. Because different industries use assets differently, ROA is most useful when comparing companies in the same industry. Construction companies, for example, use large, expensive equipment, whereas software companies use computers and servers.
Example of return of assets ratio
Mike’s Construction Company is a growing construction company with a few contracts to build downtown Chicago storefronts. Mike’s balance sheet shows that his assets began at $1,000,000 and ended at $2,000,000. Mike’s company made a net profit of $20,000,000 this year. Calculate the return of assets of Mike’s company.
Solution
The return of assets for Mike’s will be calculated using the formula:
ROE = Net income / Average total assets
Where; Net income = 20,000,000 and Average total assets = (1,000,000 + 2,000,000) / 2 = 1,500,000
ROE = 20,000,000 / 1,500,000
ROE =13.33 * 100%
ROE = 1,333.3%
Mike’s ratio is 1,333.3 percent, as you can see. In other words, for every dollar invested in assets by Mike during the year, he earned $13.3 in net income. This can be a healthy return rate regardless of the investment, depending on the economy.
To get a true sense of how well Mike is managing his assets, investors should compare Mike’s return to that of other construction companies in his industry.
Debt-to-EBITDA ratio
EBITDA means earnings before interest, taxes, depreciation, and amortization. This financial leverage ratio is a financial metric that measures the amount of income generated and available to pay off debt before interest, taxes, depreciation, and amortization. It assesses a company’s ability to repay its debts. When the ratio is high, it may indicate that the company has a high debt load.
A company can also compare its debt to its income over a given time period. The company will want to know the debt in relation to the controllable operating income. In this case, EBITDA is commonly used instead of net income. A company with a high debt-to-EBITDA ratio is carrying a lot of weight in comparison to what it produces. In other words, the higher the debt to EBITDA ratio, the more leveraged the company is.
In a formula, it is written as;
Debt-to-EBITDA ratio= Total debt / Earnings before interest, taxes, depreciation, and amortization
Summary of the financial leverage ratios
On a whole, financial leverage ratios assess a company’s ability to meet long-term debt obligations. These ratios compare a company’s overall debt load to its assets or equity, indicating how much of the company’s assets are allocated to shareholders versus creditors. Clearly, financial leverage ratios assist management and investors in understanding the risk level of a company’s capital structure.
