Leverage Ratios
Leverage ratios are financial ratios which measure a company’s ability to pay off its obligations. The most common leverage ratios are debt ratio, debt to equity ratio and equity multiplier. The equity multiplier is also called financial leverage ratio.
A proportion of debt and equity in a company’s capital structure is the most basic indicator of a company’s long-term financial health. A company must strike a good balance between debt and equity in its capital structure keeping in view the tax benefits of adding more benefits but also considering the financial risk that arises with addition of more and more debt.
The following table shows the most popular leverage ratios and their calculation formulas:
| Ratio | Debt ratio | Debt to equity ratio | Financial leverage ratio |
|---|---|---|---|
| Also called | Debt to assets ratio or gearing ratio | Equity multiplier (EM) | |
| Formula | Total Debt/Total Assets | Total Debt/Total Equity | Total Assets/Total Equity |
| Purpose | Calculates total debt as a proportion of total assets | Calculates dollars of debt per dollar of equity | It is an important input in the DuPont decomposition of return on equity |
Debt ratio is the most common leverage ratio, it is calculated by dividing the sum of short-term debt and long-term debt by the total assets.
The debt to equity ratio and financial leverage ratio cut the same pie but in different ways. The financial leverage ratio (also called the equity multiplier) has its own significance in that is the capital structure component used in decomposing return on equity in the DuPont analysis:
$$ \text{ROE}=\text{Net Profit Margin}\times \text{Total Asset Turnover}\ \times \text{Financial Leverage Ratio} $$
We can mutually convert leverage ratios using the following equation assuming total debt equals total liabilities:
$$ \text{Debt Ratio}=\frac{\text{1}+\text{D}/\text{E Ratio}}{\text{D}/\text{E Ratio}}=\frac{\text{EM}\ -\ \text{1}}{\text{EM}} $$
Degree of operating leverage and degree of financial leverage are also important indicators of a company’s financial and business risk.
Example
Given the following extract from Caterpillar’s balance sheet at the end of financial year 2017, calculate debt ratio for the company and then convert it to debt-to-equity ratio and financial leverage ratio:
| USD in million | 2017 |
|---|---|
| Total assets | 76,962 |
| Current liabilities | |
| Short-term debt | 11,031 |
| Accounts payable | 6,487 |
| Accrued liabilities | 5,779 |
| Deferred revenues | 1,193 |
| Other current liabilities | 2,441 |
| Total current liabilities | 26,931 |
| Non-current liabilities | |
| Long-term debt | 23,847 |
| Capital leases | |
| Pensions and other benefits | 8,365 |
| Minority interest | 69 |
| Other long-term liabilities | 3,984 |
| Total non-current liabilities | 36,265 |
| Total liabilities | 63,196 |
| Stockholders' equity | |
| Common stock | 5,593 |
| Retained earnings | 26,301 |
| Treasury stock | (17,005) |
| Accumulated other comprehensive income | (1,192) |
| Total stockholders' equity | 13,697 |
| Total liabilities and stockholders' equity | 76,893 |
Total debt equals the sum of interest-bearing short-term and long-term debt plus any other liabilities of debt-like nature like leases, pensions, etc. In case of Caterpillar, total debt is $43,243 million (=$11,031 million plus $23,847 million plus $8,365 million. Total assets are $76,962 million which gives us a debt ratio of 0.56 ($43,243 million divided by $76,962 million).
Debt is $43,243 million and total shareholders’ equity is $13,697 which means that debt to equity ratio is 3.16 (=$43,243 million divided by $13,697 million).
Financial leverage ratio equals total assets (i.e. $76,893 million) divided by total equity (i.e. $13,697 million), i.e. 5.6
by Obaidullah Jan, ACA, CFA and last modified on