What is Leverage Ratio
Leverage ratio is a general term for various types of financial ratio that measure the company’s financial risk and capital structure by evaluate the the company’s source of funding for it business. To put it simply, any leverage ratio shows how much the company borrowed (leveraged) compared to something such as shareholders’ equity, assets, and total debt to measure the company’s ability to pay its financial obligations.
Normally, the leverage ratios are used by accountants, analysts, investors, lenders, and managers to measure how a company uses leverage to generate income in its operations and how well it can meet financial obligations.
A higher leverage ratio indicates that a company is using capital to finance its business and operations, which is usually a clear indication that the asset may pose a risk to potential investors and vice versa.
The most common leverage ratios to measure the company’s financial health includes:
- Debt to Equity Ratio measures the number of dollars of borrowed funds for every dollar invested by investors.
- Debt to Assets Ratio measures the total amount of debt compared to the total assets of a company.
- Debt to Capital Ratio measures the company’s proportion of debt within the company’s total capital used for the operation activities.
- Assets to Equity Ratio measures how much the company uses the owner’s equity to acquire assets.
- Equity Multiplier measures
Keep in mind, although the lower leverage ratio indicates a lower debt obligation but lower leverage ratio is not necessarily a positive sign, as a company may be too reliant on equity financing, which is more expensive and a reluctance to increase debt could cause the company to miss out on growth opportunities (and tax deductibility).
Debt to Equity Ratio
The debt to equity ratio (D/E ratio) is a leverage ratio that measures the number of dollars of borrowed funds for every dollar invested by investors. The debt to equity ratio reflects a company’s leverage by comparing total debt to total equity as the following formula:
- D/E ratio = Total debt / Total equity
A high D/E ratio is often associated with risk, which means a company relies on debt to grow. However, a low D/E ratio is not necessarily a positive sign, as a company may be too reliant on equity financing, which is more expensive and a reluctance to increase debt could cause the company to miss out on growth opportunities.
Debt to Assets Ratio
The debt to assets ratio (D/A ratio) is a leverage ratio that measures the total amount of debt compared to the total assets of a company. The debt to asset ratio is used to indicate the percentage of assets that are being financed with debt. The debt to assets ratio can be computed by dividing the total debt by the total assets as the formula:
- D/A ratio = Total debt / Total assets
The lower the debt to asset ratio, the lower debt compared to the assets which mean the lower degree of leverage and financial risk.
Assets to Equity Ratio
The assets to equity ratio (A/E ratio) is a leverage ratio that measures the company’s assets financed by the investors’ equity. The value of the assets to equity ratio reflects how much the company uses the owner’s equity to acquire assets. The assets to equity ratio can be calculated by dividing the total assets by the company’s equity as the following formula:
- A/E ratio = Total Assets / Equity
When the assets to equity ratio value are greater than 1.00 means the company’s assets are more than the owner’s equity which means the company acquires those assets by debt. In contrast, when the value is less than 1.00 means the company’s assets are less than the owner’s equity.
Debt to Capital Ratio
The debt to capital ratio (D/C ratio) is a leverage ratio that measures the company’s proportion of debt within the company’s total capital used for the operation activities. The debt to capital ratio (D/C ratio) can be calculated by dividing total debt by the total capital (total debt + total equity) as the following formula:
- D/C ratio = Total debt / (Total debt + Total equity)
The lower debt to capital ratio, the lower debt the company has compared to the total capital and the lower cost of debt obligations.
Equity Multiplier Ratio
The equity multiplier ratio (EM ratio) is a leverage ratio that measures the amount of the company’s assets that are financed by shareholders’ equity. The equity multiplier ratio is a comparison between the company’s total assets and the total shareholders’ equity as the following formula:
- EM ratio = Total assets / Total equity
A higher equity multiplier indicates that the company financed its assets with debt. A lower equity multiplier indicates that the company financed its assets with its shareholders’ equity.
