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:

$$ ROE=Net\ Profit\ Margin\times Total\ Asset\ Turnover\ \times Financial\ Leverage\ Ratio $$

We can mutually convert leverage ratios using the following equation assuming total debt equals total liabilities:

$$ Debt\ Ratio=\frac{1+D/E\ Ratio}{D/E\ Ratio}=\frac{EM\ -\ 1}{EM} $$

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

Written by Obaidullah Jan, ACA, CFA and last modified on