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Leverage Ratio – Formula, Calculation and Example

Last Update Date : April 30, 2019
Estimated Read Time: 10 min

Leverage Ratio helps to find the debt usage of the company and to find the capability of the organization to meet the financial obligations. This ratio helps in understanding how the companies’ assets are financed by using debt or equity. The leverage ratio is important given that 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 its debts off as they come due.

Types of Leverage Ratio

Leverage ratio can be useful in measuring the long-term stability of the organization.

There are 5 types of Leverage Ratio, namely:

  • Equity Ratio
  • Debt Ratio
  • Debt to Equity Ratio
  • Interest Coverage Ratio
  • Capital Gearing Ratio

This ratio tells us how much contribution is made by the owners in the contribution of the organization.

Equity Ratio

This ratio tells us how much contribution is made by the owners in the contribution of the organization.

Formula

Equity Ratio = Shareholder’s equity/ Total assets

Shareholder’s Equity = Equity Share Capital + Reserve and Surplus

Analysis

  • The equity ratio tells about the financial strength of the company. It helps us to understand how much of the assets are owned by the shareholders/investors.
  • It helps to find out the owner contribution in the company.
  • It helps to measure that portion of resources which are owner’s funds or owner contribution.
  • If the ratio is high, that means the company has less amount of debt in its fund requirement. It shows less debt financing in the company.
  • It means a lot of investors are investing to a large extent in the company, and there is very less usage of debts in the company.
  • It can mean that the company is a conservative company and wants or needs less amount of debts in its capital structure
  • Also, equity financing in capital structure can be a much cheaper option than paying for debt financing.
  • A higher ratio indicates a good position of the company in the long-term

Example

A company has shareholders’ funds Rs 18,00,000 and total assets Rs 30,00,000 and liabilities Rs 29,00,000

Equity Ratio = Shareholder’s equity/ Total assets
= 18,00,000/30,00,00
= 0.62

This means that approximately 60% of the funds are financed by equity shareholders and remaining 40% through debt funds.

The company comparatively has a high usage of equity as compared to debt usage, and it is good for the company in maintaining a long-term solvency position.

Debt Ratio

This ratio is opposite to equity ratio. It helps to measure the amount of debt by which assets are purchased in the organisation. It helps to find out the debt obligations of the company. It measures the portion of companies’ resources which are funded by debt.

Formula

Debt Ratio = Total Debt/ Total Assets

Analysis

  • It helps to find out the amount of debt used for financing the assets in the organisation.
  • It helps us to understand the financial leverage of the company.
  • It tells us the degree of leverage utilised by the company.
  • A high ratio means a huge amount of debt is used for financing the assets and very less equity is used. It can be risky to the organisation as debt attracts a lot of interest payment
  • A debt ratio can tell us how risky it will be for the bank to extend a loan to the organisation. If the ratio is high, then it indicates more risk

Example

A company has the following financial information

  • Total debt- Rs 2,00,000
  • Total equity- Rs 1,00,000
  • Total assets – Rs 3,00,000

Debt Ratio = Total Debt/ Total Assets
= 2,00,000/ 3,00,000
= 0.67

This means around 67% of assets are financed by total debt. The more the debt company has, higher will be the debt ratio. There is a high component of debt used to purchase the assets.

A higher ratio can be riskier to the company during the liquidation of the company. A lower ratio means a company has a conservative approach and does not want the usage of debt component.

But, it also depends on the type of industry and company in which it operates.

Debt to Equity Ratio

This ratio is a financial ratio which tells us the relationship between the debts employed and the shareholders’ funds. It tells us about the financial soundness of the organisation

Formula

Debt Equity Ratio = Total debt/Shareholders’ funds

Analysis

  • This ratio measures the ability of the company to repay its debt obligations. It helps in judging the financial standing of the company. When the repayment capacity of the company has to be analysed, it is important to find out the debt-equity ratio.
  • If a company has to borrow capital, then investors and lenders will check the repayment capacity and the debt-equity ratio.
  • The companies with high ratio may not attract too many lenders. Also, the repayment capacity may become risky in case of liquidation of the company.
  • A higher ratio means a greater degree to which operations are funded by borrowed money.
  • A lower ratio means a lower amount of financing by borrowed funds.
  • This ratio helps in finding the amount of debt borrowed in connection to the equity funds provided by the shareholders.
  • Debt equity ratio is finding out the extent of leverage the company has taken. Through this ratio, we can find out, how much geared a company is by borrowing external funds.
  • Optimum debt-equity ratio is 1:1, where liabilities are equal to assets. But, the ratio also depends on the industry type and company
  • A high ratio also means the company is in an aggressive position and financing its growth with debt.
  • A low ratio can also mean that the company is not taking advantage of increased profits and not utilising it to a higher extent and taking benefit which financial leverage can bring.

Example

A company has the following information:

  • Short term debt – Rs. 5,00,000
  • Long term debt – Rs 18,00,000
  • Equity share capital – Rs. 7,50,000
  • Retained earnings – Rs 15,00,000

Debt equity ratio = Total debt/ Shareholders’ funds
= 23,00,000/22,50,000
= 1.02

This means the company has a good ratio, wherein the debt funds and equity funds are in an equal amount. And in case of liquidation, company can pay back the funds.
Also, company is utilising the funds in a better manner where the usage of debt is not very high.

Interest Coverage Ratio

This is a financial ratio which helps the company to find out whether it can pay its interest on the debt taken.

It helps to understand the number of times the interest can be paid with Earning before interest and taxes.

The interest coverage ratio acts as a safety measure for the company; it can find out how much funds are there for paying the interest before even paying the principal amount.

Formula

Interest Coverage Ratio = Earnings before interest and taxes (EBIT)/ Interest Expense

Analysis

  • It helps us to find out the ability of the company to pay interest on outstanding debt.
  • It is used by stakeholders like creditors, investors and lenders to determine the risk of lending money to the organization.
  • It helps to measure the number of times interest can be paid with the earnings of the organization.
  • The lower the interest coverage ratio, the more is the burden on the company.
  • Generally, an interest coverage ratio below 1 indicates a company is not generating sufficient revenues to meet its interest expenses.
  • Interest coverage ratio is a good assessment of the short-term financial health of the organization.

Example

Earnings before interest and tax- Rs 3,00,000
Interest expenses- Rs 25,000

Interest Coverage Ratio = Earnings before interest and taxes (EBIT)/ Interest Expense
= 3,00,000/25,000
= 12 times

This means that the company has 12 times more amount than the interest expense. The company is in a very comfortable position for payment of interest expenses.

Capital Gearing Ratio

It relates to the capital structure of the company. It tells us how much geared or leveraged a company is. Through this company can find out the proportion of usage of debt.

Formula

Capital Gearing Ratio = Fixed income bearing funds/Total capital employed

Fixed income bearing funds = debentures + long-term loans

Total capital employed = equity share capital + preference share capital + reserves

Analysis

  • Capital Gearing ratio is also called as financial leverage. It helps us to understand up to what level the company is geared or taking borrowed funds.
  • A highly geared company can earn more profits as compared to a conservative company, but it can also be at risk as it has to pay more interest on the borrowed loan.
  • Capital Gearing Ratio is one of the important ratios when investors want to invest in a company. It gives an idea about how much geared the company is i.e. using fixed interest-bearing funds.

Example

A company has the following information:
Long-term debt bearing interest = Rs. 5,00,000
Shareholders’ equity = Rs. 3,00,000

Capital Gearing Ratio = 5,00,000/ 3,00,000
= 1.67

This means the company has more gearing as compared to the owner’s capital. It has to pay interest for the debt employed which is more than the owner’s capital.

Leverage

Leverage is also called as Trading on Equity. The use of fixed return bearing securities like preference share capital, debentures, bonds, term loans etc. to increase the earning available to equity shareholders is called as Trading on Equity. It refers to the practice of using borrowed funds and preference share capital carrying a fixed charge in expectation of obtaining a higher return to the equity shareholders.

Since, the equity shareholders are considered as the owners of the company and all investments, financing and dividend decisions are taken in a view of maximisation of wealth of the owners. Hence, trading on equity or leverage has a direct impact on shareholders.

Operating Leverage

The operating leverage can be defined as the firms’ ability to use fixed operating cost to magnify the effects of changes in sales on its earnings before interest and tax (EBIT). The company will not have operating leverage if its fixed operating cost is zero. It is related to fixed cost. High operating leverage indicates a high risky situation, as it consists of large fixed costs.

Formula

Operating Leverage = Contribution/EBIT

Or

Operating Leverage = % change in EBIT/ % change in sales

Example

A company has the following information:
Selling price = Rs 10/unit
Variable cost = Rs 6/unit
Fixed operating cost = Rs 15,000
Sales units = 10,000

Sales10,000 units * 10 each1,00,000
(-) Variable cost10,000 units * 6 each   60,000
Contribution    40,000
(-) Fixed Cost    15,000
 EBIT    25,000

Degree of operating leverage (DOL) = Contribution/ EBIT
= 40,000/25,000
= 1.6

Financial Leverage

Financial Leverage can be defined as the use of fixed charges securities in the capitalization of the company. The use of fixed charges securities such as debt and preference capital along with the owners’ equity in the capitalization of the company is described as financial leverage. It explains the impact of earning per share.

Formula

Degree of Financial Leverage (DFL) = EBIT/EBIT

Or

Degree of Financial Leverage (DFL)= % change in EPS/ % change in EBIT

Example

Company has the following information:

Equity Capital (Rs. 10 each)4000
Debt4000
EBIT  600

Interest at 10% pa

Calculation of DFL

EBIT600
Interest400
EBT 200

Financial leverage = 600/200
DFL = 3

Combined Leverage

Formula

Combined Leverage = Operating leverage x Financial leverage

DCL = Contribution/EBIT

Example

Two companies have the following information

ParticularsP Ltd (Rs. In lacs)Q Ltd (Rs. In lacs)
Sales500 1000
(-) Variable cost200   300
 Contribution300    700
(-) Fixed Cost150    400
     EBIT150    300
(-) Interest  50    100
     EBT100    200
Particulars  P Ltd Q Ltd
 Combined leverage= Contribution/ EBT  300/ 100 700/ 200
Combined Leverage     = 3   = 3.5

The higher the combined leverage, the more it is risky.

Importance of Leverage Ratios

  • It helps to find out the gearing of the organization i.e. how much is the debt obligation of the company in comparison to the shareholders’ funds.
  • A leveraged firm can have more profits than a non-leveraged firm. But it also means high risk for the company as the company has to pay fixed interest on it.
  • A leveraged firm can earn more for the shareholders; it helps in wealth maximization of the shareholders.
  • Leverage gives the option of using more funds in the view of earning high returns.
  • A non-leveraged firm is considered as a conservative firm as it does not utilise third-party funds or employ debt with a view of earning higher returns.

Uses of Leverage Ratios

  • It helps to measure the solvency of the company by checking the amount of debt and equity
  • It helps in proper planning of the capital structure of the company
  • It helps in assessing the ability of the firm to meet financial obligations
  • It helps to find out the amount of debt that a company can borrow and pay fixed interest on it.
  • Leverage ratios act as a measure for the lenders and creditors who want to invest in the companies

People Also Ask

Q. What is gearing in finance?

A. Gearing means a measure of debt usage in the company. It means how much is the leverage i.e. the usage of fixed interest-bearing securities. The costs of the company increase due to gearing as it has to pay interest for borrowing the debt. Gearing determines the level of risk in a company

Q. Why there is a need for leverage in the organization?

A. Gearing focuses on the long-term stability of the company. The use of external funds means that the company is utilizing its profits and want to take advantage of the profit situation by expansion or utilization of borrowed funds. High leverage can mean risk for the company. But it depends on the type of industry and firm.

Q. What is a good financial leverage ratio?

A. Leverage ratio (debt-equity ratio) of 0.5:1 is considered an ideal ratio. An ideal situation is where half of the equity or own funds are utilized for borrowing debt. It means there are sufficient assets to pay the interest as well as maintain a non- risky level from the viewpoint of lenders and creditors.

Q. What does a leverage ratio of 1.8 mean?

A. This means when the debt is 1.8, the equity is 1. For every equity of Re 1, we have to pay a debt of Rs 1.8. We are paying more than the amount which we have. For every Re 1, we owe a debt of Rs 1.8. This means the firm is highly leveraged and can be risky. It also means that creditors and lenders will be cautious to lend money to the firm.

Leverage can be termed as a double-edged sword. The firm has to utilize the gearing properly to gain an optimum capital structure. If the firm has a sufficient and correct amount of gearing, it can earn more profits. This helps the firm in its growth and expansion. Leverage, if utilized properly, can be a boon for the company.

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Chetan Chandak (B.Com, LLB)
Chetan is the Head of Tax Research at H&R Block (India) with an experience of more than a decade in tax advising. He is also a regular contributor for some of the leading news publications in India such as Economic Times, Financial Express and Money Control. Professionally, Chetan is fascinated by international taxation and expat-related tax research.

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