Leverage Ratio

Businesses cost huge amount of cash to run, and that money needs to come from somewhere. After all, it takes money to make money. Regularly, businesses fund their operations with a mix of loans and equity.
Loans are borrowed amounts of money that must be paid back over time with interest, and equity is ownership in the business itself. Publicly traded companies issue stock (equity) to the public in exchange for capital.

What Is a Leverage Ratio and What Does It Tell Us?

A leverage ratio is a metric that expresses the degree to which a company's operations are funded by debt (borrowed capital). The most well known leverage ratio — the debt-to-equity ratio — compares a company's debt to its owners' equity. Companies whose operations are funded fundamentally through debt (in other words, companies with high debt-to-equity ratios) are described as being very "leveraged."
Leverage isn't necessarily something bad. It is normal for companies — especially newer companies and those in growth phases — to borrow capital to develop and expand. Inasmuch as payments are made on time, expansion can continue, and additional borrowing remains an option.
That being said, the more debt a company carries relative to its equity and/or assets, the riskier of an investment it tends to be for shareholders. If a company's revenue isn't high enough to keep up with its debt, it might become insolvent and could even fail.

What Are the 2 Main Leverage Ratios?

As mentioned above, the most famous leverage ratio used by investors to examine a company's reliance on debt is the D/E ratio, which compares debt to equity directly. Another commonly used metric is the debt-to-total assets ratio. This ratio expresses the extent of a company's assets that are financed with borrowed money.
Note: Short and long-term debt, shareholders' equity, and total assets can be in every way found on a company's public financial statements.

1. Debt-to-Equity Ratio

To calculate a company's debt-to-equity ratio, essentially divide its total debt by its shareholders' equity.

Debt-to-Equity Ratio Formula

D/E = (Short-Term Debt + Long-Term Debt)/Shareholders' Equity

2. Debt-to-Total Assets Ratio

To calculate a company's debt-to-total assets ratio, divide its total debt by its total assets.

Debt-to-Total Assets Ratio Formula

D/TA = (Short-Term Debt + Long-Term Debt)/Total Assets

Step by step instructions to Interpret a Company's D/E Ratio

A D/E ratio of 1 (this can likewise be expressed as 100% or 1:1) indicates that a company's operations are funded equally by debt and shareholders' equity. In other words, its debt and equity are equal. A ratio of less than 1 indicates that more of a company's operations are funded by equity than debt, while a ratio of more than 1 indicates the opposite — that more of a company's operations are financed by debt than by equity.

Step by step instructions to Interpret a Company's D/TA Ratio

A D/TA ratio of 0.5 (this can likewise be expressed as half) indicates that half of a company's assets were financed with debt and half were financed with equity. A ratio of below 0.5 means that more of a company's assets were funded by equity than debt, while a ratio of above 0.5 means the opposite — that more of a company's assets were paid for with borrowed cash than with equity.

When Are Leverage Ratios Useful?

Leverage ratios — like most financial metrics used by investors to evaluate companies — are most useful when looking at two or more companies inside the same industry. Different industries have different standards in terms of debt and financing, so contrasting the leverage ratio of a bank to that of an automaker would not provide a lot of knowledge.
Looking at the leverage ratios of two companies inside the same industry, then again, could provide valuable information about which may be a safer investment. It's important to note, however, that safer investments aren't generally better investments. Riskier investments can provide more substantial returns, yet they can likewise result in larger losses.
In the section below, we use leverage ratios to compare Microsoft and Apple, two large and famous computer companies.

Leverage Ratio Example: Microsoft versus Apple

Looking at the leverage ratios of Microsoft (Nasdaq: MSFT) and Apple (Nasdaq: AAPL) can't tell us which company is a better investment, nor could it at any point tell us which company's stock price is a better value. It can, however, tell us how reliant on debt each company currently is to support its operations. In times of economic uncertainty — like bear markets and recessions — companies that are less reliant on debt might be safer investments.
Note: The figures below come from the 2021 financial statements of Microsoft and Apple.

Microsoft's Leverage Ratios

Debt to Equity

D/E = (Short-Term Debt + Long-Term Debt)/Shareholders' Equity

D/E = (1.96 + 71.45)/141.99

D/E = 73.41/141.99

D/E = 0.517

Debt to Total Assets

D/TA = (Short-Term Debt + Long-Term Debt)/Total Assets

D/TA = (1.96 + 71.45)/333.78

D/TA = 73.41/333.78

D/TA = 0.219

Apple's Leverage Ratios

Debt to Equity

D/E = (Short-Term Debt + Long-Term Debt)/Shareholders' Equity

D/E = (7.45 + 119.38)/63.09

D/E = 126.83/63.09

D/E = 2.01

Debt to Total Assets

D/TA = (Short-Term Debt + Long-Term Debt)/Total Assets

D/TA = (7.45 + 119.38)/351

D/TA = 126.83/351

D/TA = 0.361

From these leverage ratios, obviously starting around 2021, Apple was more debt-reliant than Microsoft.
Apple's debt accounted for about twice as a lot of its operations as its equity, whereas Microsoft's debt accounted for just about half as quite a bit of its operations as its equity. Around 22% of Microsoft's total assets were financed by debt, whereas around 36% of Apple's total assets were financed by debt.
Overall, these metrics tell us that Apple is more highly leveraged than Microsoft and therefore may be a riskier investment (inside the computer industry) during bear markets or periods of economic decline.

What Does a High Leverage Ratio Mean?

As mentioned above, one company's leverage ratios being higher than another's doesn't mean a lot on the off chance that the two companies are in different industries, especially if one has been around for much longer than the other.
Inside an industry, however, assuming two companies are of comparable size and age, and one has fundamentally higher leverage ratios, that could indicate that it is a riskier investment, especially during periods of low revenue. If the two companies have revenue troubles, the one with the higher leverage ratios is more likely to become insolvent.

What Does a Low Leverage Ratio Mean?

In the event that two companies are comparable (in terms of industry, size, and age), yet one has fundamentally lower leverage ratios than the other, the less-leveraged company could be considered a safer investment. On the off chance that the two companies struggle to achieve revenue, the less-leveraged company is less likely to become insolvent.

What Is a Good Leverage Ratio?

What is considered a "good" or below average leverage ratio varies considerably by industry, as certain types of companies are by nature more reliant on debt than others to fund operations. For instance, the average D/E ratio in the auto industry as of January 2022 was around 0.2, while the average for money center banks was 1.7.

Average D/E Ratios by Industry

Highlights

• Common leverage ratios include the debt-equity ratio, equity multiplier, degree of financial leverage, and consumer leverage ratio.
• Banks have regulatory oversight on the level of leverage they are can hold.
• A leverage ratio is any of several financial measurements that assesses the ability of a company to meet its financial obligations.
• A leverage ratio may likewise be used to measure a company's mix of operating expenses to get an idea of what changes in output will mean for operating income.