Understanding Types Of Leverage Ratios

A leverage ratio measures the proportion of capital in the capital structure of the company that is contributed in the form of debt or loans or assesses the ability of a company to meet its financial obligations. It is of paramount importance for the companies since the capital structure of a company is generally funded by a mix of equity and debt, and the company must evaluate and have an idea whether it can pay off its debts as they are due, without posing much threat or difficulties to the regular ongoing operations.

Relying on heavy debts can be risky for a company and its investors. However, if a company can generate a higher rate of return than the interest rate, then resorting to debt could be beneficial, since it can add to the growth of the profits. The proportion of debt and equity is significant to find an optimum capital structure of the company to determine the cost of funds.

There are several different specific ratios that may be classified as a leverage ratio, however, below are few detailed leverage ratios:

Debt-to-Equity: The debt to equity ratio is the most common leverage ratio, calculated by dividing total liabilities by shareholders equity. Generally, long-term debts which are Interest-bearing in nature are considered as the liabilities in the calculation. The ratio indicates the mix of equity and debt used to finance the assets. A lower DE ratio is considered as good from risk perspective as too much debt obligations exposes the company to default in case of failures. Even lenders are reluctant to offer loans to highly leveraged firms. Besides, an extremely low DE ratio is not preferable by investors with company not financing expansion and diversification plans from borrowing.

Debt-to-Capital: The debt-to-capital ratio measures the financial leverage of the company. Here debt includes all short-term and long-term obligations whereas capital includes the company's debt and shareholder's equity. The ratio is used to evaluate the financial structure of the company and how it is financing its operations. A high debt-to-capital ratio may indicate a higher risk of default by the company compared with its peers.

Debt-to-EBITDA: The Debt-to-EBITDA ratio is usually used by the credit rating agencies, which determines the probability of defaulting on debt issued by the company. It is a measurement of whether a company can pay off its debts and also determine how many years of EBITDA would be necessary to repay all the debts especially for companies with huge debts on their balance sheets. An example may be oil & gas companies. The ratio varies depending on the industry however anything above 3 is very high. Another variation of this ratio is Debt/EBITDAX where EBITDAX is EBITDA before exploration costs.

Equity Multiplier or Total Asset-to-Equity: The formula for the ratio is company's total asset value/ total net equity. Total Asset-to-Equity measures the financial leverage of the company. Higher equity multiplier suggests that the company has financed a larger portion of its asset using debt.

Interest Coverage Ratio: The interest coverage ratio, as the name suggests, whether a firm can meet or cover the interest payments on its outstanding debts. The formula used is EBIT/Interest Expense. A higher ratio indicates a lesser risk to the lender. A multiple higher than 1 is considered very healthy generally.

The above leverage ratios are mainly used by the analysts; however, there can be several other leverage ratios that the analyst might use as per requirement. In any of the circumstances, these ratios must be viewed in conjunction with other valuation metrics and factors of the company for better understanding and valuation.

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