Leverage ratio: Meaning, formula and how to calculate

Have you ever wondered how companies manage to expand or make investments even if they don't have much cash on hand? This happens due to something called leverage, which, in simpler terms, means borrowing money to seek to grow faster. Understanding leverage ratio can help you make better investment decisions. But what is leverage ratio and why is it important? Let's take a closer look at this interesting financial concept.

• Table of contents

• What is leverage ratio?
• Formula for leverage ratio
• How to calculate leverage ratio
• Example of leverage ratio calculation
• What does a leverage ratio tell you?
• Advantages and disadvantages of financial leverage
• List of common leverage ratios
• What is a good leverage ratio?
• Leverage ratio vs. coverage ratio: What’s the difference?
• Leverage ratio and mutual funds

What is leverage ratio?

A leverage ratio is a simple financial measure that shows how much a company borrows compared to its own money (equity). Leverage ratio indicates how much of the company's money comes from debt, like loans, and how much comes from its own funds, like profits or shareholder investments.

• High leverage ratio: More borrowing, higher risk.
• Low leverage ratio: Less borrowing, potentially lower risk.

Knowing the meaning of leverage ratio can help investors understand how risky a company could be to invest in.

Read Also: How arbitrage funds leverage market volatility

Formula for leverage ratio

The basic leverage ratio formula is quite straightforward:

Leverage Ratio = Total Debt / Total Equity

• Total debt: All the money borrowed by the company (like loans, bonds).
• Total equity: The company's own money (like shareholders' funds).

How to calculate leverage ratio

Here's a simple method that tells you how to calculate leverage ratio:

1. Find out the company's total debt from its financial statement.
2. Find out the company's total equity from the same statement.
3. Use the formula given above and divide total debt by total equity.
4. The answer you get is the leverage ratio.

Example of leverage ratio calculation

To make it clear, let’s look at an easy example:

• Suppose a company has:
  • Total debt = Rs. 50 lakh
  • Total equity = Rs. 25 lakh

Now, let's calculate the leverage ratio:

Leverage Ratio = Rs. 50,00,000 / Rs. 25,00,000 = 2

So, we conclude that the company has a leverage ratio of 2. This means that the company has borrowed twice as much as its own money.

What does a leverage ratio tell you?

Leverage ratio helps you understand the financial strength of a company:

• High leverage ratio: Shows the company relies heavily on borrowed money, which can indicate higher growth potential but might be risky if profits decline.
• Low leverage ratio: Indicates the company mainly uses its own money, making it relatively lower risk during difficult economic times.

Advantages and disadvantages of financial leverage

Advantages:

• Helps companies grow quickly without needing large amounts of their own cash.
• Allows businesses to expand and earn higher profits.

Disadvantages:

• Too much debt can lead to financial stress.
• Risk of bankruptcy if the company cannot repay loans.

List of common leverage ratios

The following are some common types of leverage ratios:

• Debt-to-equity ratio: This is the most common. It measures total debt compared to total equity, indicating how much borrowed money a company uses.
• Debt-to-assets ratio: Compares total debt to total assets, showing what portion of the company’s assets is financed through debt.
• Debt-to-capital ratio: Shows how much debt the company uses relative to its total capital (debt + equity).

What is a good leverage ratio?

Generally speaking:

• A good leverage ratio is usually below 2.
• A ratio of 1 or lower is considered excellent.
• Ratios above 3 might signal higher risk.

However, what’s considered a "good" leverage ratio also depends on the industry. Companies like banks naturally have higher leverage, while tech companies usually have lower leverage.

Leverage ratio vs. coverage ratio: What’s the difference?

Both metrics indicate a company’s financial health, but there are some key differences, as follows:

• Leverage ratio: Measures how much a company is using debt compared to its own equity or assets. It shows how heavily the company relies on borrowed money.
• Coverage ratio: Measures whether a company generates enough earnings to comfortably pay its debt obligations (like interest or loan repayments). It reflects how well the company can manage its existing debt.

Leverage ratio and mutual funds

You may wonder how leverage ratio is connected to mutual funds. Those who invest in mutual fund can also benefit from understanding leverage ratios. Mutual funds that invest in companies with low leverage ratios tend to be safer investments, while those investing in high-leverage companies may have higher risk but potentially higher returns. Because mutual funds are professionally managed, fund managers look out for factors like leverage ratio while making investment decisions.

Read Also: What are leveraged ETFs and are they worth the risk?

Conclusion

Understanding the concept of leverage ratio can be valuable for an investor. A suitable balance of debt and equity can lead to growth, while too much debt can be risky. By calculating and regularly checking this ratio, investors can make wiser investment decisions and keep their money safer.

FAQs

What is the formula for leverage ratio?

The formula to calculate leverage ratio is total debt divided by total equity:
Leverage ratio = Total debt/Total equity

What is a good value for a leverage ratio?

Usually, a leverage ratio below 2 is considered good. Below 1 is excellent, while anything above 3 may indicate higher financial risk.

What are some examples of leverage ratios?

Common leverage ratios include debt-to-equity ratio, debt-to-assets ratio, debt-to-capital ratio, and interest coverage ratio.

How can the leverage ratio be improved?

A company can improve its leverage ratio by increasing profits and using them to pay off debt, issuing more shares to raise equity, and minimising use of borrowed money for future growth.

Is there a way to lower the leverage ratio?

A company can lower its leverage ratio by paying off existing loans or debts quickly, increasing its profits or income, while also making sure to avoid taking new loans until finances are more stable.