Leverage Ratio: What It Is, What It Tells You, and How to Calculate

What Is a Leverage Ratio?

A leverage ratio is a measurement used to determine the relationship between a company’s debt and assets. It can be used to measure the amount of capital in the form of debt and loans, or to assess a company’s ability to meet its financial obligations.

Leverage ratios are important in business, finance, and economics because companies and institutions rely on a mixture of equity and debt to finance their operations. Knowing the amount of debt held is useful in evaluating whether it can be paid off as it comes due.

How Does a Leverage Ratio Work?

Leverage ratios assess the ability of a company, institution, or individual to meet their financial obligations. Carrying too much debt can be dangerous for a company and its investors, but the debt may help fuel growth if a company’s operations can generate a higher rate of return than the interest rate on its loans.

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

A leverage ratio might 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. Operating costs can be fixed or variable. The mix will differ depending on the company and the industry.

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 Corp. (FDIC) protection has produced a banking environment with limited lending risks. The FDIC, the Federal Reserve, and the Office of the Comptroller of the Currency (OCC) 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 can’t be written down because the bank’s bondholders and depositors are owed these funds.

The Federal Reserve created guidelines for bank holding companies, but these restrictions vary depending on the rating assigned to the bank. Banks that experience rapid growth or face operational or financial difficulties are generally 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. These pressures haven’t gone away. Restrictions keep getting tighter.

Regulators periodically adjust capital requirements for banks, particularly after financial crises or bank failures, often requiring larger banks to hold more capital to reduce systemic risk. These restrictions limit the number of loans made because it’s 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.

Types of Leverage Ratios

There are many different types of leverage ratios—here are a few.

Debt-to-Equity (D/E) Ratio

The debt-to-equity (D/E) ratio is perhaps the most well-known financial leverage ratio. It’s expressed as:

Debt-to-Equity Ratio = Total Liabilities ÷ Total Shareholders’ Equity

​For example, if a company has $20 billion in debt and $16 billion in equity, its debt-to-equity ratio would be 1.25.

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

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. It may increase the company’s chances of default or bankruptcy if the company’s interest expense grows too high.

Equity Multiplier

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

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

Assume that Company A 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

Debt isn’t specifically referenced in the formula, but it’s an underlying factor given that total assets include debt. The company’s high ratio of 4.59 indicates that assets are mostly funded with debt rather than equity. Company A’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​

It’s generally better to have a low equity multiplier because this means that a company isn’t incurring excessive debt to finance its assets.

Debt-to-Capitalization Ratio

The debt-to-capitalization ratio measures the amount of debt in a company’s capital structure. It’s 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​

Operating leases are capitalized, and equity includes both common and preferred shares. An analyst might decide to use total debt to measure the debt used in a firm’s capital structure instead of using long-term debt. This formula 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 calculated using the formula:

$\begin{aligned} &DFL = \frac{\% \text{ change in }EPS}{\% \text{ change in }EBIT} \\ &\textbf{where:}\\ &EPS=\text{earnings per share}\\ &EBIT=\text{earnings before interest and taxes}\\ \end{aligned}$​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. Interest is usually a fixed expense, so 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.

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. High levels of consumer debt are often associated with economic growth during expansion periods, but excessive debt can also increase financial risk and has been linked to past economic downturns.

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

Debt-to-Capital Ratio

The debt-to-capital ratio focuses on the relationship of debt liabilities as a component of a company’s total capital base. It’s calculated by dividing a company’s total debt by its total capital, which is the sum of total debt and 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 finances its operations. The higher the debt-to-capital ratio, the higher the risk of default is. Earnings may not be enough to cover the cost of debts and liabilities if the ratio is very high. A reasonable debt-to-capital ratio depends on the industry. Some sectors use more leverage than others.

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. This ratio is commonly used by credit agencies. It’s calculated by dividing short- and long-term debt by EBITDA. It determines the probability of defaulting on issued debt.

This ratio is useful in determining how many years of earnings before interest, taxes, depreciation, and amortization (EBITDA) would be required to pay back all the debt. It can be alarming if the ratio is over 3.0, but this can vary by industry.

Debt-to-EBITDAX Ratio

The debt-to-EBITDAX ratio is similar to the debt-to-EBITDA ratio. It 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 various accounting treatments for exploration expenses: The full cost method vs. the successful efforts method. Exploration costs are typically found in financial statements as exploration, abandonment, and dry hole costs. Other non-cash expenses that should be added back are impairments, accretion of asset retirement obligations, and deferred taxes.

Interest Coverage Ratio

The interest coverage ratio is also concerned with interest payments. One problem with only reviewing a company’s total debt liabilities is that it doesn’t reveal anything about its ability to service the debt. The interest coverage ratio aims to fix this.

This ratio equals operating income divided by interest expenses. It showcases the company’s ability to make interest payments. A ratio of 3.0 or higher is generally desirable, but it varies by industry.

Fixed-Charge Coverage Ratio

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

Find the company’s earnings before interest and taxes (EBIT), then divide this by the interest expense of long-term debts. Use pretax earnings because interest is tax-deductible. The full amount of earnings can eventually be used to pay interest. Higher numbers are more favorable.

Explain It Like I’m Five

A leverage ratio shows how much money a company has borrowed compared to what it owns or earns. Borrowing money can help a company grow, but too much borrowing can be risky.
Leverage ratios help investors see whether a company has a safe amount of debt or too much. 

The Bottom Line

Leverage ratios are useful tools. They provide a simple way to evaluate the extent to which a company or institution relies on debt to fund and expand its operations. Debt can generate a higher rate of return than it costs when it’s used effectively, but too much is dangerous and can lead to default and financial loss. Leverage ratios are most useful to look at in comparison to past data or a comparable peer group.