Business 101: Guide to Financial Leverage Ratio

A financial leverage ratio compares the total liabilities (or total debt) of a given company against its partial or total assets. This proportion of debt tells those interested how much of a business’ operating income comes from positive assets like total shareholders’ equity, profitability, and net income, compared to how much of the company’s total capital comes from borrowed money. Higher debt leads to higher leverage ratios, and vice versa.

A company’s financial leverage is determined by that company’s ability to maintain the level of debt it accrues alongside the balance sheet it aims to keep healthy. This leads to continued solvency with its lenders and higher profit margins for its investors. In other words, a leverage ratio measures whether or not the use of leverage—or use of debt—undergirds a solid capital structure.

If a company’s debt financing is high compared to its total equity (or it has a high leverage ratio), potential stockholders may worry the company’s status as a heavy borrower and its high debt load overall could lead to a financial crisis (like an inability to meet fixed costs or a default on interest expense repayment).

If a company’s debt obligations compared to the rest of the money on its income statement are lower (or it has a low leverage ratio), that lower amount of debt will routinely lead investors to be less worried about volatility.

Still, there are exceptions in which a high operating leverage ratio is not a cause for concern (for example, the company’s valued so highly that it’s nearly impossible to believe it won’t be able to pay back its debts) or a lower operating leverage reveals the company is actually on thin ice (for instance, if creditors won’t extend loans to a company at all because of its shaky finances).

Financial leverage ratios paint a nuanced picture of businesses in relation to other metrics you can obtain from their financial statements. Here are four key things this sort of ratio can tell you:

1. 1. Ability to absorb variable costs: The amount of money a business needs can fluctuate depending on a host of factors, so a leverage ratio can tell you a lot about whether or not a business can meet these sorts of variable costs. If a company’s debt-to-equity ratio is exceedingly high and it hits a bad quarter, it may not be able to obtain further liquidity or cash flow from its creditors.
2. 2. Adherence to financial obligations: The degree of financial leverage (DFL) a company takes on can indicate whether or not it will be able to meet its obligations to financial institutions, employees, or investors. For example, if a business is routinely not bringing in enough money to cover the interest rate payments on long-term debt, it could be a sign of trouble for overall return-on-equity (ROE).
3. 3. Type of business overall: Some business types actually thrive with a greater degree of operating leverage. For instance, many companies focusing on manufacturing turn a better profit when a company uses borrowed assets and makes interest payments on them rather than owning them outright, due to the depreciation on assets like these over time. Conversely, service-oriented industries are generally more successful with fewer debts. This is just one example of why a high debt-to-capital ratio or a greater degree of financial leverage isn’t always a cause for concern.
4. 4. Willingness to take risks: Leveraging debt can also be an indicator that a company knows itself and takes risks when necessary. Sometimes, borrowing money will eventually lead to a greater rate of return on investment (ROI) in the future. As long as other capital requirements are being met, a leverage ratio need not scare off investors. Depending on other factors, this sort of debt-to-equity ratio could actually be a sign of sound business strategy.

While there are different types of leverage ratios of varying degrees of complexity, the basic formula for one is very simple. You divide the total amount of debt (D) by the total amount of company assets (A) to get the leverage ratio (L). You can visualize this like so: L = D/A.

All investments and investment strategies entail inherent risks and introduce the potential for financial loss or the depreciation of assets. The information presented in this article is for educational, informational, and referential purposes only. Consult a professional investment advisor before making any financial commitments.

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