What is a Leverage Ratio?
A leverage ratio is a critical financial measurement that evaluates how much capital comes in the form of debt (loans) and assesses a company’s ability to meet its financial obligations. This metric is crucial because companies often use a mixture of equity and debt to finance their operations. Understanding the level of debt held by a company is vital for evaluating its financial health and potential risks.
Key Takeaways
- A leverage ratio helps assess a company’s ability to meet its financial obligations.
- It can also measure a company’s mix of operating expenses, impacting operating income.
- Common leverage ratios include the debt-equity ratio, equity multiplier, degree of financial leverage, and consumer leverage ratio.
- Banks have regulatory oversight concerning their leverage levels.
What Does a Leverage Ratio Tell You?
Leverage ratios primarily assess a company’s ability to meet its financial obligations. Excessive debt can be risky, but if managed well, debt can fuel growth by yielding higher returns than the interest rates on loans. Uncontrolled debt can lead to credit downgrades or worse, while too little debt may indicate tight operating margins.
Various leverage ratios consider debt, equity, assets, and interest expenses. It’s also possible to measure a company’s mix of operating expenses to see how changes in output affect operating income. Another important ratio is the consumer leverage ratio, which compares consumer debt to disposable income for economic analysis.
The key to understanding leverage is knowing that debt can amplify returns as well as losses.
Banks and Leverage Ratios
Banks are among the most leveraged institutions. With fractional-reserve banking and FDIC protection creating a limited lending risk environment, three regulatory bodies – the FDIC, the Federal Reserve, and the Comptroller of the Currency – oversee and restrict banks’ leverage ratios. They regulate how much a bank can lend relative to its capital.
The scrutiny on leverage ratios has intensified since the Great Recession. In 2023, following the collapse of several lenders, regulators proposed increasing the capital cushions for banks with $100 billion or more in assets. For banks, the tier 1 leverage ratio is commonly used by regulators.
Common Leverage Ratios
The Debt-to-Equity (D/E) Ratio
This ratio is calculated as:
Debt-to-Equity Ratio = \frac{\text{Total Liabilities}}{\text{Total Shareholders' Equity}}
For example, if a company has a long-term debt of $19.35 billion and total stockholders’ equity of $20.0 billion, the D/E ratio would be:
Debt-to-Equity Ratio = \frac{$19.35 billion}{$20.0 billion} = 0.97
Higher D/E ratios indicate potential risk, but this largely depends on industry norms.
The Equity Multiplier
The equity multiplier is calculated as:
Equity Multiplier = \frac{\text{Total Assets}}{\text{Total Equity}}
For example, if Macy’s has assets valued at $19.85 billion and stockholder equity at $4.32 billion, the ratio would be:
$19.85 \text{ billion} ÷ $4.32 \text{ billion} = 4.59
A high ratio means that assets are primarily funded by debt rather than equity.
The Debt-to-Capitalization Ratio
This ratio measures debt within a company’s capital structure:
\text{Total Debt to Capitalization} = \frac{(SD + LD)}{(SD + LD + SE)}
Operating leases and both common and preferred shares are included in equity for this calculation.
Degree of Financial Leverage
Degree of financial leverage (DFL) measures EPS sensitivity to changes in operating income due to capital structure changes:
DFL = \frac{\text{Percentage Change in EPS}}{\text{Percentage Change in EBIT}}
Higher DFL indicates potentially higher EPS volatility.
The Consumer Leverage Ratio
This ratio is used to measure average consumer debt relative to disposable income:
Consumer Leverage Ratio = \frac{\text{Total Household Debt}}{\text{Disposable Personal Income}}
High consumer debt can influence corporate earnings and economic stability.
Other Key Ratios
- Debt-To-Capital Ratio refocuses on a company’s capital structure.
- Debt-To-EBITDA Ratio anticipates how many years of EBITDA it takes to repay debt.
- Debt-To-EBITDAX Ratio is similar but focuses on industries with exploration costs (e.g., oil and gas).
- Interest Coverage Ratio evaluates a company’s ability to service debt through operating income.
- Fixed-Charge Coverage Ratio assesses cash flow relative to interest owed on long-term liabilities.
The Bottom Line
Leverage ratios are invaluable tools for assessing a company’s reliance on debt. Properly used, debt can enhance returns beyond its cost. However, overreliance on debt may lead to financial turmoil. Effective leverage ratio analysis considers industry norms and historical performance to draw meaningful insights.
Related Terms: debt, equity, assets, interest expenses, financial leverage.
References
- FDIC. “Capital”, Page 2.
- Federal Reserve. “Bank Holding Company Supervision Manual”, Page 1-54.
- The Federal Reserve Bank of Cleveland. “A Brief History of Bank Capital Requirements in the United States”.
- The Federal Deposit Insurance Corporation. “Fact Sheet: Proposed Rules to Strengthen Capital Requirements for Large Banks”.
- Bank For International Settlements. “Definition of capital in Basel III – Executive Summary”.
- The Federal Reserve. “Annual Large Bank Capital Requirements”.
- UPS. “Quarterly earnings and financials”.
