Leverage Ratio: What It Is, What It Tells You, How To Calculate

What Is a Leverage Ratio?

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 category is important because 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 off its debts as they come due. Several common leverage ratios are discussed below.

What Does a Leverage Ratio Tell You?

In most cases, leverage ratios assess the ability of a company to meet its financial obligations. 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 may help to fuel growth.

Uncontrolled debt levels can lead to credit downgrades or worse. On the other hand, too few debts can also raise questions. A reluctance or inability to borrow may indicate that operating margins are tight.

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. 

Another leverage ratio is the consumer leverage ratio. This ratio looks at the level of consumer debt compared to disposable income and is used in economic analysis and by policymakers.

Banks and Leverage Ratios

Banks are among the most leveraged institutions in the United States. The combination of fractional-reserve banking and Federal Deposit Insurance Corporation (FDIC) protection has produced a banking environment with limited lending risks.

To compensate for this, three separate regulatory bodies, the FDIC, the Federal Reserve, and the Comptroller of the Currency, review and restrict the leverage ratios for American banks. These bodies restrict how much money a bank can lend relative to how much capital the bank devotes to its own assets. The level of capital is important because banks can "write down" the capital portion of their assets if total asset values drop. Assets financed by debt cannot be written down because the bank's bondholders and depositors are owed those funds.

Banking regulations for leverage ratios are complicated. The Federal Reserve created guidelines for bank holding companies, although these restrictions vary depending on the rating assigned to the bank. In general, banks that experience rapid growth or face operational or financial difficulties are required to maintain higher leverage ratios.

The level of scrutiny paid to leverage ratios has increased since the Great Recession of 2007 to 2009 when banks that were "too big to fail" were a calling card to make banks more solvent. And these pressures haven't gone away. Restrictions keep getting tighter.

In 2023, following the collapse of several lenders, regulators proposed banks with $100 billion or more in assets dramatically add to their capital cushions. These restrictions naturally limit the number of loans made because it is more difficult and more expensive for a bank to raise capital than it is to borrow funds. Higher capital requirements can reduce dividends or dilute share value if more shares are issued.

For banks, the tier 1 leverage ratio is most commonly used by regulators.

Leverage Ratios

There are many different leverage ratios. Below we look at some of the more common ones.

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

Perhaps the most well-known financial leverage ratio is the debt-to-equity ratio. This is expressed as:

$\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Total Shareholders' Equity}}$Debt-to-Equity Ratio=Total Shareholders’ EquityTotal Liabilities​

For example, in the quarter ending June 30, 2023, United Parcel Service's long-term debt was $19.35 billion and its total stockholders' equity was $20.0 billion. The company's D/E for the quarter was 0.97.

A high debt/equity ratio generally indicates that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If the company's interest expense grows too high, it may increase the company's chances of a default or bankruptcy.

Typically, a D/E ratio greater than 2.0 indicates a risky scenario for an investor; however, this yardstick can vary by industry. Businesses that require large capital expenditures (CapEx), such as utility and manufacturing companies, may need to secure more loans than other companies.

The Equity Multiplier

The equity multiplier is similar, but replaces debt with assets in the numerator: 

$\text{Equity Multiplier} = \frac{\text{Total Assets}}{\text{Total Equity}}$Equity Multiplier=Total EquityTotal Assets​

For example, assume that Macy's has assets valued at $19.85 billion and stockholder equity of $4.32 billion. The equity multiplier would be:

$\$19.85 \text{ billion} \div \$4.32 \text{ billion} = 4.59$$19.85 billion÷$4.32 billion=4.59

Although debt is not specifically referenced in the formula, it is an underlying factor given that total assets includes debt.

Remember that total assets = total debt + total shareholders' equity. The company's high ratio of 4.59 means that assets are mostly funded with debt rather than equity. From the equity multiplier calculation, Macy's assets are financed with $15.53 billion in liabilities.

The equity multiplier is a component of the DuPont analysis for calculating return on equity (ROE):       

$\begin{aligned} &\text{DuPont analysis} = NPM \times AT \times EM\\ &\textbf{where:}\\ &NPM=\text{net profit margin}\\ &AT=\text{asset turnover}\\ &EM=\text{equity multiplier}\\ \end{aligned}$​DuPont analysis=NPM×AT×EMwhere:NPM=net profit marginAT=asset turnoverEM=equity multiplier​

The Debt-to-Capitalization Ratio

The debt-to-capitalization ratio measures the amount of debt in a company’s capital structure. It is calculated as:

$\begin{aligned} &\text{Total debt to capitalization} = \frac{(SD + LD)}{(SD + LD + SE)}\\ &\textbf{where:}\\ &SD=\text{short-term debt}\\ &LD=\text{long-term debt}\\ &SE=\text{shareholders' equity}\\ \end{aligned}$​Total debt to capitalization=(SD+LD+SE)(SD+LD)​where:SD=short-term debtLD=long-term debtSE=shareholders’ equity​

In this ratio, operating leases are capitalized and equity includes both common and preferred shares. Instead of using long-term debt, an analyst may decide to use total debt to measure the debt used in a firm's capital structure. The formula, in this case, would include minority interest and preferred shares in the denominator.

Degree of Financial Leverage 

Degree of financial leverage (DFL) is a ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. It measures the percentage change in EPS for a unit change in earnings before interest and taxes (EBIT) and is represented as:

 $\begin{aligned} &DFL = \frac{\% \text{ change in }EPS}{\% \text{ change in }EBIT} \\ &\textbf{where:}\\ &EPS=\text{earnings per share}\\ &EBIT=\text{earnings before interest and taxes}\\ \end{aligned}$​DFL=% change in EBIT% change in EPS​where:EPS=earnings per shareEBIT=earnings before interest and taxes​

DFL can alternatively be represented by the equation below:

 $DFL = \frac{EBIT}{EBIT - \text{interest}}$DFL=EBIT−interestEBIT​

This ratio indicates that the higher the degree of financial leverage, the more volatile earnings will be. Since interest is usually a fixed expense, leverage magnifies returns and EPS. This is good when operating income is rising, but it can be a problem when operating income is under pressure.

The Consumer Leverage Ratio

The consumer leverage ratio is used to quantify the amount of debt the average American consumer has relative to their disposable income.

Some economists have stated that the rapid increase in consumer debt levels has been a contributing factor to corporate earnings growth over the past few decades. Others blamed the high level of consumer debt as a major cause of the Great Recession.

$\text{Consumer leverage ratio} = \frac{\text{Total household debt}}{\text{Disposable personal income}}$Consumer leverage ratio=Disposable personal incomeTotal household debt​

The Debt-To-Capital Ratio

The debt-to-capital ratio is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a company's total capital base. It is calculated by dividing a company’s total debt by its total capital, which is total debt plus total shareholders’ equity. Debt includes all short-term and long-term obligations.

This ratio is used to evaluate a firm's financial structure and how it is financing operations. Generally, the higher the debt-to-capital ratio is, the higher the risk of default. If the ratio is very high, earnings may not be enough to cover the cost of debts and liabilities.

Again, what constitutes a reasonable debt-to-capital ratio depends on the industry, Some sectors use more leverage than others.

The Debt-To-EBITDA Leverage Ratio

The debt-to-EBITDA leverage ratio measures the amount of income generated and available to pay down debt before a company accounts for interest, taxes, depreciation, and amortization expenses. Commonly used by credit agencies, this ratio, which is calculated by dividing short- and long-term debt by EBITDA, determines the probability of defaulting on issued debt.

This ratio is useful in determining how many years of EBITDA would be required to pay back all the debt. Typically, it can be alarming if the ratio is over 3, but this can vary depending on the industry.

The Debt-To-EBITDAX Ratio

The debt-to-EBITDAX ratio is similar to the debt-to-EBITDA ratio. It just measures debt against EBITDAX rather than EBITDA. EBITDAX stands for earnings before interest, taxes, depreciation (or depletion), amortization, and exploration expense. It expands EBITDA by excluding exploration costs, a common expense for oil and gas companies.

This ratio is commonly used in the United States to normalize different accounting treatments for exploration expenses (the full cost method versus the successful efforts method). Exploration costs are typically found in financial statements as exploration, abandonment, and dry hole costs. Other noncash expenses that should be added back in are impairments, accretion of asset retirement obligations, and deferred taxes.

The Interest Coverage Ratio

Another leverage ratio concerned with interest payments is the interest coverage ratio. One problem with only reviewing the total debt liabilities for a company is they do not tell you anything about the company's ability to service the debt. This is exactly what the interest coverage ratio aims to fix.

This ratio, which equals operating income divided by interest expenses, showcases the company's ability to make interest payments. Generally, a ratio of 3.0 or higher is desirable, although this varies from industry to industry.

The Fixed-Charge Coverage Ratio

Times interest earned (TIE), also known as a fixed-charge coverage ratio, is a variation of the interest coverage ratio. This leverage ratio attempts to highlight cash flow relative to interest owed on long-term liabilities.

To calculate this ratio, find the company's earnings before interest and taxes (EBIT), then divide by the interest expense of long-term debts. Use pre-tax earnings because interest is tax-deductible; the full amount of earnings can eventually be used to pay interest. Again, higher numbers are more favorable.

The Bottom Line

Leverage ratios are useful tools. They provide a simple way to see the extent to which a company relies on debt to fund its operations and expand. Debt is important. When used effectively, it can generate a higher rate of return than it costs. However, too much is dangerous and can lead to default and financial ruin.

Leverage varies by industry. Certain types of companies rely on debt more than others and banks are even told how much leverage they can hold. Leverage ratios work best when compared to the past or a peer group.