Importance of Leverage Ratio Explained with It's Meaning and Types

Leverage ratio allows one to analyse the extent of debt on which a company depends in order to build capital or acquire assets. Entities build capital through a mixture of debt and equity instruments, and this ratio tells us the level of capital that a company has generated through debt.

Continue reading to know more about what is a leverage ratio, types of leverage ratios and their importance.

Investors, as well as creditors, use this critical financial ratio to assess the debt repayment capacity of an entity. This also helps in understanding the structure of capital of an entity, i.e., the amount of capital raised by selling equity and amount of capital raised from debt instruments.

Some of the most common examples of leverage ratios that analysts use are debt to EBITDA ratio, debt to assets ratio and debt to equity ratios. All these ratios have different working and convey different aspects of debt management.

Financial institutions use leverage ratios to ascertain the level of core capital that an entity has acquired with regard to its total assets. Now that you are aware of the meaning of leverage ratio, let's move on to its other aspects.

You can get a fair idea about the debt management capability of a company by looking at leverage ratios. High levels of debt may be unsustainable in the long run and can discourage investors from taking a stake in the company.

On the other hand, if a company can generate a higher rate of return than the rate of interest payable, it may be beneficial for them to go into more debt. However, if the debt levels breach the tolerance band of a company, it can lead to severe credit rating downgrades. Moreover, a lack of appetite for debt may not be a good sign as well. It may indicate tighter operating margins.

A leverage ratio consists of certain factors like debt, assets, equity and interest payable. You can use various leverage ratios to analyse a firm’s operating expenses and how any changes in a company’s output will affect its operating income.

Policymakers use consumer leverage ratios to analyse consumers' debt levels in comparison to their disposable income and take appropriate policy decisions to ensure stability.

1. Financial Leverage

A financial leverage ratio helps investors determine the level or amount of debt that it has or aims to borrow in order to finance their operations. A company uses borrowed funds to undertake business activities, as using loans instead of giving up their equity can improve a company's earnings per share.

Using debts for running a business operation can improve the return on investment if the returns generated are higher than the rate of interest payable. However, companies must be cautious while dealing with debts, as excessive use of debt can threaten their stability.

2. Operating Leverage

The operating leverage is a ratio of fixed costs to variable costs of an entity. One can also calculate this as a percentage of fixed costs to variable costs. An entity that shows a higher leverage ratio indicates higher fixed costs in its operations.

Generally, an entity with high fixed costs is a capital-intensive firm. A very small change in its volume may drastically affect its profits and return on investment. These companies may face negative affinities if higher fixed costs do not correspond to higher earnings because of decreased market demand.

A firm having a high fixed cost to revenue ratio, preferably more than 50%, may come under high operating leverage companies. On the other hand, a firm having a fixed cost to revenue ratio of lower than 20% may be categorised as a low operating leverage firm.

3. Combined Leverage

It is a combination of operating and financial leverage. This type of leverage ratio comes in handy when one goes through the balance sheet or income statement. In case of income statements, the operating leverage ratio influences the operating income section. On the other hand, in case of a balance sheet, the financial leverage takes hold by analysing earnings per share.

Mentioned below are the reasons why leverage ratios are important:

• It helps prospective and current investors know about the financial health of a company. It tells them whether the company is in a position to fulfil its debt obligations or not.
• There are two ways of raising capital – sale of equity and debt. Different companies use different strategies to raise capital. This ratio helps better understand the structure of a company’s gross working capital.
• Investors get clarity about the company by assessing the leverage ratios. If the company is overburdened with debt, it may not be an ideal investment option. Similarly, if the company is scarce of debts, its earnings may get hampered in the long run.
• Various financial institutions use these leverage ratios to analyse the debt repayment capacity of specific entities.

Lenders use leverage ratio as a metric in various loan agreements and documents to regulate risk factors and ensure that borrowing parties do not undertake high profile risky actions that will threaten their stability. There is a provision for a maximum limit on the total leverage metric, and these restrictions are referred to as debt covenants. For informational purposes, there are two types of debt covenants or agreements, namely maintenance and incurrence covenants.

If a company breaches the restrictions mentioned in a covenant, banks will consider that as a technical default and impose fines or penalties and, in certain cases, may demand immediate repayment of loans. Corporate banks are quite strict with these leveraging limits while negotiating a credit agreement.

Leverage ratio is an important financial tool which enables individuals and creditors to gauge the debt management of a company. The various leverage ratios also provide crucial insight into the debt repayment capability of a company. This detailed guide about what is a leverage ratio and its working aspects will give a better understanding of the concept to its readers.