- Aditya Battu

# Leverage ratios : Explained

Updated: Jul 15, 2020

**How do I know if a company has taken too much debt to fund its growth?**

In the previous article on financial ratios, we have covered the liquidity ratios in detail. If you have missed out on reading it, you can find the link for the post __here__

Now we move on to the next set of ratios, which are the **leverage ratios**, one of the most important ratios in determining the financial health of the company

**What are leverage ratios and why are they important?**

Leverage ratios are used for evaluating the debt levels of the company. They help us track if the company is comfortably placed in handling its debt obligations or if its debt levels are too high, which might hamper the profitability of the company in the future

Before going through the ratios, there are some terms which we need to understand while dealing with leverage ratios:

**What does "leverage" mean?**

Leverage means taking debt to finance the expansion projects / purchase assets for the company

**What does it mean when we say that a company is "highly leveraged"?**

It means that the company has more debt than equity. High leverage is often associated with high risk since the company is using huge debt to grow and there is a chance of diminishing profits due to increasing interest payments on these debts

Most of companies which have become bankrupt were highly leveraged: used more and more debt to fund growth but couldn’t ensure the required cash flows to pay them back with interest being compounded

Now that we have understood what leverage means, let’s jump into some of the most commonly used leverage ratios in the industry:

Debt to Equity ratio

Debt to Assets ratio

Debt to EBIDTA ratio

Interest coverage ratio

Out of all the above ratios, **Debt to Equity ratio** is the most important and commonly used ratio by most of the analysts to analyze the debt levels of the company

We’ll follow the same example that we have used in the case of liquidity ratios, calculating leverage ratios for our company **Marvel, **which is into the business of manufacturing and selling cars

And its financial statements read as follows:

Given this scenario, let’s understand the leverage position of Marvel by looking at the values of the 3 ratios:

**1. Debt to equity ratio**:

= (Total liabilitites) / (Total shareholders’s equity)

=(Short term debt + Long term debt + Other fixed payments ) / Total shareholders’ equity

= (200+500+100)/600

= **1.3**

Now, how do we address if 1.3 good or bad? To conclude if the ratio of 1.3 is good for Marvel or not:

You have to compare the ratios with the peers in the same industry

Look at the trend and observe if it is increasing/decreasing over the years. Decreasing /steady ratios with increasing revenues is considered a good sign for the company

Look at what the debt is being used for. If its used for funding growth, for e.g., entering into new markets/new products with good future prospects, then it is okay for the company to have a high debt-to-equity ratio at present, but is expected to decrease in the future once the company starts doing well

Also, the optimal debt-to-equity ratio varies across industries:

Capital intensive industries such as Marvel in this case, which is a car manufacturing company, usually have higher debt-to-equity ratios of around 1-1.5

For less-capital intensive industries it tends to be on the lower side, somewhere around 0.5

**2. Debt to Assets ratio:**

This ratio tells investors/creditors if the assets of the company are financed by debt or equity. In simple words, did I acquire assets using debt or shareholders’ equity.

If most of the assets are funded by debt, its more riskier, since it raises a question of profitability of the company

Assets here include both tangible (machinery, equipment etc) as well as intangible (goodwill, brand recognition, patents, intellectual property etc)

For Marvel, this ratio:

= (Total liabilitites) / (Total assets)

=(Short term debt + Long term debt + Other fixed payments ) / Total assets

= (200+500+100)/900

= **0.89**

Marvel's 89% of the assets are funded by debt, hence could be a concern for the company

Also, creditors will keep this in mind while lending fresh loans. They usually prefer lower debt-to-assets ratio companies

Again, you have to compare these with the peers from the same industry and also track the trend over years to take a call on the financial risk of the company

**3. Debt to EBIDTA ratio:**

This ratio is pretty straightforward and popular with analysts in determining if the company is earning enough income to pay back its debt. It indicates the company’s ability to decrease its debts

If the ratio is on the higher side, then the company might not be able to pay back its debt on time, in which case, it could run into a risk of default

Let’s look at this ratio for Marvel:

= (Total liabilitites) / (EBIDTA)

=(Short term debt + Long term debt + Other fixed payments ) / EBIDTA

= (200+500+100)/200

= **4**

Its 4, which is slightly on the higher side. Ratios which are typically higher than 4 or 5 set off alarm bells ringing because this might indicate that the company is less likely to be able to handle the debt burden

However, the optimal ratio differs from industry to industry. Take a call if it is good or bad for your company only after comparing it with its peers in the same industry

**4. Interest coverage ratio:**

This ratio tells us if the company is well placed to make the interest payments regularly on the debt it has taken. It is often used by lenders /creditors to assess the risk of lending to the firm and by investors to assess the financial health of the company

For Marvel,

=EBIT/Interest Expense

=150/50

=**3**

Usually when a company’s interest coverage ratio is 1.5 or lower, its ability to meet interest expense may be questionable. Here, with an interest coverage ratio of 3, Marvel seems to be in a comfortable position to cover its interest payments using the income its earning currently

Hope you have now understood the importance of leverage ratios and can use them effectively in determining the financial risk for your company of interest

*We’ll look at the next set of ratios, which are the efficiency ratios, in our next post*