What is the leverage ratio?

A leverage ratio evaluates a company’s financial leverage by assessing the extent to which it relies on debt to finance operations and acquire assets. It compares the borrower’s debt burden on the balance sheet with key financial metrics like cash flow, assets, and total capitalization to measure a company’s ability to meet financial obligations.

What is leverage ratio, and why does it matter in corporate finance?

Leverage ratio is any kind of financial measurement that evaluates a company’s level of debt relative to another financial metric. It can provide an indication of how a business finances its operations and growth (i.e. through borrowing or equity) and the extent to which it's utilizing borrowed funds. Businesses and investors use leverage ratios to analyze a company’s capital structure and financial health.

In corporate finance, leverage ratios are important because they can help a company assess their ability to meet financial obligations. Companies often fund their operations through a mix of debt and equity, and understanding the extent of their debt helps them evaluate whether they can manage repayments as they become due.

Having high leverage can increase a company's exposure to financial risk, but may also enhance potential returns if a company achieves a return on investment that exceeds the interest rate on its loans. If leverage is excessive, however, a business may struggle to meet debt obligations or face credit downgrades. Maintaining an appropriate level of leverage can allow a business to pursue growth opportunities without overextending resources.

Financial leverage ratios are used by creditors to assess whether a company can handle additional borrowing or if its debt levels pose too much risk. Investors use leverage ratios when deciding whether to invest in a business.

Types of leverage ratios

Below are some of the most common leverage ratios used to assess a company’s financial health and risk:

Debt-to-equity (D/E) ratio

The debt-to-equity (D/E)  ratio compares a company’s total liabilities to its shareholders’ equity. It’s calculated as:

Debt-to-Equity Ratio = Total Liabilities / Total Shareholders’ Equity

A high D/E ratio often suggests a company has been financing aggressive growth through debt. This can lead to volatile earnings due to rising interest expenses. If interest expenses become too high, a company may be at risk of bankruptcy or default.

D/E ratios higher than 2.0 can indicate risk; however, this varies by industry. Industries with high capital requirements, like utilities or manufacturing, often have higher acceptable D/E ratios.

When interpreting the D/E ratio, it’s helpful to measure it against historical performance and against similar companies in the same industry.

Equity multiplier

The equity multiplier is similar to the D/E ratio, it only focuses on how much of a company’s assets are financed by debt. It’s calculated as:

Equity Multiplier = Total Assets / Total Equity

Although the equity multiplier doesn’t specifically reference debt, it indirectly incorporates it since total assets comprise both debt and shareholders’ equity (total assets = total debt + total shareholders’ equity). A high equity multiplier indicates that a large portion of a company’s assets are financed with debt, which can suggest higher financial risk depending on the industry.

Debt-to-capitalization ratio

The debt-to-capitalization ratio measures the proportion of debt within a company’s total capital structure. It’s calculated as:

Total Debt-to-Capitalization= (SD + LD) / (SD + LD + SE)

Where:

SD = Short-term debt

LD = Long-term debt

SE = Shareholders’ equity

Companies with a higher debt-to-capitalization ratio often rely more heavily on debt. 

Debt-to-EBITDA leverage ratio

The debt-to-EBITDA ratio measures a company’s debt relative to its earnings before interest, taxes, depreciation, and amortization expenses. It’s calculated by:

Debt-to-EBITDA = Total Debt / EBITDA

This ratio can be used to determine how many years of earnings (before interest, taxes, depreciation, and amortization) would be needed to pay off total debt. It’s often used by credit agencies to assess a company’s likelihood of default.

Generally, debt-to-EBITDA ratios higher than three may be a concern. However, acceptable thresholds depend on the industry and a company's specific circumstances.

Debt-to-EBITDAX ratio

This is a variant of the debt-to-EBITDA ratio, using EBITDAX instead of EBITDA. EBITDAX refers to earnings before interest, taxes, depreciation (or depletion), amortization, and exploration costs. The addition of exploration expenses makes this ratio more relevant for oil and gas companies. It’s calculated as:

Debt-to-EBITDAX = Total Debt / EBITDAX

Interest coverage ratio

The interest coverage ratio measures a company’s ability to pay interest on its debt. It’s calculated by: 

Interest Coverage Ratio = Operating Income / Interest Expenses

What’s considered an acceptable interest cover ratio can vary by industry; however a ratio of 3.0 or higher usually indicates a company has sufficient income to meet interest obligations.

Fixed-Charge Coverage Ratio

Times interest earned (TIE), also known as a fixed-charge coverage ratio, is a variation of the interest coverage ratio. This leverage ratio attempts to highlight cash flow relative to interest owed on long-term liabilities.

To calculate this ratio, find the company’s earnings before interest and taxes (EBIT), then divide by the interest expense of long-term debts. Use pretax earnings because interest is tax-deductible; the full amount of earnings can eventually be used to pay interest. Again, higher numbers are more favorable.

What is the operating leverage ratio in financial analysis?

The operating leverage ratio measures how sensitive a company’s operating profit is to changes in revenue.

If a company has a high operating leverage, it means it has a large percentage of fixed costs in its operations. In these situations, a small shift in revenue could lead to significant changes in profitability. These firms are often capital-intensive, such as automobile manufacturers, which require significant investments in equipment and infrastructure.

While high operating leverage can magnify earnings during periods of strong sales, it also increases risk. If sales decline, the fixed costs remain constant and can potentially lead to financial strain if unable to be covered by revenues.

If a company’s fixed costs are more than 50% of revenue, it may be considered to have high operating leverage. If fixed costs make up less than 20% of revenue, it suggests the company has low operating leverage.

Why companies with high leverage ratios face more financial risk

Although high leverage can potentially lead to greater returns, it can also cause greater risk, particularly for companies with both high financial and operating leverage ratios.

If a company's financial leverage ratio is high, it often means heavy reliance on borrowed funds to finance operations. If the return on investment (ROI) fails to exceed the interest paid on this debt, the company’s profitability can be negatively affected. This can lead to reduced earnings per share and limit the company’s ability to reinvest or meet its financial obligations, increasing the risk of default.

Similarly, a high operating leverage ratio signals that a company has significant fixed costs compared to its sales. In these situations, even a minor decrease in revenue can make it challenging for a business to cover its operational expenses. This imbalance can reduce profitability and increase the risk of losses if sales fail to recover.

If both ratios are high, the risks compound. The company would face pressure from fixed costs and debt obligations simultaneously, leaving little room for financial flexibility. This is especially true in industries with higher market volatility, where financial stability is heavily reliant on debt management. For that reason, it's important for a business to balance leverage with sustainable revenue generation and cost management.

How leverage ratios impact financial decision-making

Leverage ratios are used by lenders, investors, management, and valuation analysts to provide insight into a company’s financial structure and risk profile and guide decision-making.

Lenders use leverage ratios to measure risk by evaluating a company’s ability to manage its debt obligations. This is important for industries, where fluctuating market conditions can impact creditworthiness. Some creditors may set maximum allowable limits for leverage ratios in their credit agreements. If a company exceeds these thresholds, the lender may impose restrictions, such as limiting debt issuance or dividend payments.

Investors use leverage ratios as benchmarks for assessing a company’s financial health and stability. They may compare a firm’s leverage ratio against historical performance and industry peers when deciding whether to invest in the company or provide debt financing.

Management teams use leverage ratios to guide decisions about capital structure and growth and assess the feasibility of taking on additional debt for expansion or other growth initiatives. If leverage ratios are acceptable, a company can confidently pursue growth strategies, while those with high leverage may focus on reducing debt to maintain financial stability.

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This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.