Leverage Ratio - Definition, Types and Formula

Leverage ratio is one of the most essential of the financial ratios as it indicates how much of the capital in the firm is in the form of indebtedness. It also assesses how the firm can satisfy its responsibilities.

It becomes increasingly significant as it evaluates the capital structure of the firm and the way it can manage its capital structure so that it can pay off the loans.

Meaning of Leverage Ratio

A leverage ratio is a financial metric utilized to assess the extent to which a company relies on borrowed funds, such as debt, in relation to its equity or capital. It offers insights into the proportion of a firm's total assets that are funded by external sources, indicating the level of financial risk and potential vulnerability to economic fluctuations.

Leverage Ratio for Banks

The leverage ratio for banks is a crucial metric assessing financial stability by comparing a bank's capital to its assets, revealing reliance on borrowed funds. Calculated by dividing Tier 1 capital by average total consolidated assets, a higher ratio signifies a stronger buffer against losses. This ratio, emphasized by regulatory frameworks like Basel III, complements risk-based capital requirements, bolstering public trust, preventing excessive risk-taking, and contributing to overall financial stability, thus playing a vital role in banking supervision and fostering a secure and resilient banking sector.

Leverage Ratio for NBFCs

The leverage ratio for Non-Banking Financial Companies (NBFCs) is a pivotal metric assessing financial strength, measuring the ratio of Tier 1 capital to average assets. This indicator offers insights into the extent of an NBFC's reliance on borrowed funds, serving as an early warning tool for potential risk. A higher ratio signifies a more substantial capital cushion and an enhanced loss capacity. By emphasizing prudent leverage, this ratio supports NBFCs in maintaining stability, ensuring robust risk management, and reinforcing investor confidence, thereby contributing to a resilient and secure financial ecosystem.

Types of Leverage Ratio

Understanding the leverage ratios is crucial for investors and analysts when evaluating a company's financial health. Here, we present various types of leverage ratios in simple terms:

Debt-to-Equity Ratio (D/E Ratio):

The debt-to-equity ratio compares a company's total debt to its total equity, revealing how much external financing is used relative to internal equity. A higher D/E ratio suggests a greater reliance on debt, potentially increasing financial risk.

Debt Ratio:

The debt ratio shows the proportion of a company's debt-financed assets. It is obtained by dividing the total debt by the total assets. A higher debt ratio implies a larger portion of assets is funded through debt.

Equity Ratio:

In contrast to the debt ratio, the equity ratio highlights the proportion of assets funded by equity (owner's investment). A higher equity ratio signifies a stronger financial position.

Times Interest Earned (TIE) Ratio:

The TIE ratio assesses a company's capacity to finance interest costs from operational income. It is computed by subtracting interest expenditure from EBIT. A larger TIE ratio indicates better interest payment coverage.

Fixed Charge Coverage Ratio:

This ratio considers interest expenses and fixed contractual payments like leases. It provides a comprehensive view of a company's ability to meet its fixed financial commitments.

Debt Service Coverage Ratio (DSCR):

The DSCR assesses a company's capacity to cover all debt obligations, including principal and interest payments, with its operating income. A higher DSCR reflects a lower default risk.

Operating Leverage:

Operating leverage relates to a company's fixed versus variable costs. A higher proportion of fixed costs indicates higher operating leverage, potentially leading to amplified profit changes based on revenue fluctuations.

Equity Multiplier:

The equity multiplier evaluates the financial leverage effect by measuring the relationship between a company's total assets and its equity. It is calculated by dividing total assets by total equity. A higher equity multiplier signifies a greater use of debt to finance assets.

Leverage Ratio Formula

The formulas for different leverage ratios are presented below:

Debt-to-Equity Ratio (D/E Ratio):

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

Explanation: To calculate the D/E ratio, divide the company's total debt by its total equity. This ratio offers insights into how much external borrowing is compared to the internal equity investment.

Debt Ratio:

Formula: Debt Ratio = Total Debt / Total Assets

Explanation: The debt ratio is found by dividing the total debt by the total assets. This ratio provides an understanding of the percentage of a company's assets that are funded through debt.

Equity Ratio:

Formula: Equity Ratio = Total Equity / Total Assets

Explanation: Calculate the equity ratio by dividing total equity by total assets. This ratio shows what percentage of a company's assets are funded by equity.

Times Interest Earned (TIE) Ratio:

Formula: TIE Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

Explanation: The TIE ratio is obtained by dividing EBIT by the interest expense. It reveals how many times a company's operating earnings can cover its interest payments.

Fixed Charge Coverage Ratio:

Formula: Fixed Charge Coverage Ratio = (EBIT + Fixed Charges) / (Interest + Fixed Charges)

Explanation: Calculate the fixed charge coverage ratio by adding EBIT and fixed charges, then dividing it by the sum of interest and fixed charges. This ratio assesses a company's ability to meet both interest and fixed contractual payments.

Debt Service Coverage Ratio (DSCR):

Formula: DSCR = Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) / Total Debt Service

Explanation: The DSCR is determined by dividing EBITDA by the total debt service. It measures a company's capacity to cover all debt-related payments.

Operating Leverage:

Formula: Operating Leverage = Contribution Margin / Operating Income

Explanation: Calculate operating leverage by dividing the contribution margin (revenue minus variable costs) by the operating income (EBIT). This ratio shows the impact of fixed and variable costs on a company's profits.

Equity Multiplier:

Formula: Equity Multiplier = Total Assets / Total Equity

Explanation: The equity multiplier is found by dividing total assets by total equity. It highlights the extent to which a company relies on debt to finance its assets.