Leverage ratios are financial ratios that specify the level of debt incurred by a business relative to other accounting heads on its balance sheet. For example, the debt-to-equity ratio is a leverage ratio that displays the total amount of debt for a business in relation to its stockholder equity. While they were originally designed to evaluate companies in the stock market, leverage ratios have become important tools after the 2008 financial crisis to prevent systemically-important financial institutions from defaulting or going bankrupt. Leverage ratios are different from liquidity ratios, which are primarily used to measure the amount of liquidity available to a company to fund their operations and their debt obligations. Primarily, leverage ratios are used for two purposes: Leverage ratios are not set in stone and can vary between industries and sectors. In an industry with relatively few competitors and high profits, high leverage ratios or debt loads are acceptable for companies operating in that industry. But the same analysis does not hold true for industries in which there are many competitors and profit margins are thin. A small or mid-sized outfit operating in such an industry may not be able to pay back debt, even if it generates profits because its success depends on manufacturing volume. As such, any analysis using leverage ratios should take into consideration the specifics of an industry and market. Generally, a company's debt is measured against five accounts: total assets, total equity, total operating expenses, and total income. As such, common leverage ratios are measured against these parameters. The five most-used leverage ratios are: Leverage ratios are generally assigned scores starting from 0.1. A leverage ratio of 1 means the company has equal amounts of debt and the other, comparable metric being measured. A leverage ratio greater than 1 may not be a good sign because it means that the company has high levels of debt and not enough assets or earnings to make payments for that debt. For example, a leverage ratio of 2:1 means that the company owes $2 for every $1 invested in it. A score of 1 is the ideal leverage ratio for companies but some industries have ratios greater than 1 due to the nature of their operations. For example, companies in the manufacturing and retail sector have leverage ratios much greater than 1 because they have high inventory numbers, which are included in debt calculations, to operate efficiently. As such, it is always better to compare leverage ratios between companies in a particular industry instead of comparing them across industries. After the financial crisis of 2008, a new leverage ratio to measure the capital adequacy of financial institutions in the event of a crisis was introduced by the Basel Committee on Banking Supervision in 2009. This leverage ratio is known as the Tier 1 leverage ratio and measures the total amount of Tier 1 Capital available to a bank in relation to other assets. Tier 1 Capital consists of the most liquid assets available to a bank in case of a financial crisis. For example, Treasury Bonds are considered part of Tier 1 Capital because they can be liquidated easily and there is a ready market available for them. The formula to calculate Tier 1 Leverage Ratio is: Tier 1 Leverage Ratio = Tier 1 Capital/Consolidated Assets X 100 Under Basel III regulations, systemically-important financial institutions should have a minimum leverage ratio of 6% to ensure that they are able to survive a financial crisis. Using Leverage Ratios in Analysis
Debt generally gets a bad rep but it has its advantages. For example, interest payments on certain kinds of debt are tax-deductible and can reduce the overall amount of debt that a company incurs.
A leverage ratio greater than 1 indicates that the company is operating with significant amounts of debt and may not be able to service its future payments on that debt.
Similarly, the Assets-to-Equity ratio can be used to measure its assets versus stockholder equity. Together, both ratios provide a window into the company's spending and debt allocations.Measuring Leverage Ratios
Tier 1 Leverage Ratio
Leverage Ratio FAQs
Leverage ratios are financial ratios that specify the level of debt incurred by a business relative to other accounting heads on its balance sheet.
For example, the debt-to-equity ratio is a leverage ratio that displays the total amount of debt for a business in relation to its stockholder equity.
Leverage ratios are indicators of a company’s ability to meet its short-term and long-term debt obligations. A leverage ratio greater than 1 indicates that the company is operating with significant amounts of debt and may not be able to service its future payments on that debt.
While a score of 1 is the ideal leverage ratio for companies, some industries have ratios greater than 1 due to the nature of their operations.
The five most-used leverage ratios are: debt-to-assets ratio; debt-to-equity ratio; debt-to-capital ratio; debt-to-EBITDA ratio; asset-to-equity ratio.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
