All about leverage ratios

If you want to play chess - you need to know the classic opening moves and likewise to succeed in finance, it also helps to know important financial ratios like all the main leverage ratios.

Leverage ratios (also known as solvency ratios) allow you to determine your company’s financial risk and are a way of determining a company’s long-term debt relative to total equity. Most lenders will use leverage ratios to assess the potential risk of a company before deciding to lend to them.

Leverage ratios vs liquidity ratios

Leverage ratios look at total liabilities , a company’s capital structure and long term solvency of an organization. While liquidity ratios compare short-term debt and assets that can be quickly converted into cash - measuring the of short term viability of a company.

Why leverage ratios matter?

Most companies rely on both equity and debt to finance operations. Leverage ratios provide a view of the level of debt a business is carrying. They answer the all-important question, “Does the organization have the cashflow to service and repay the debt?”

Lenders often use leverage ratios to help them assess an organization’s funding risk. As ratios improve or deteriorate, it can directly affect the interest rates an organization will be charged.

A higher or increasing leverage ratio may mean that your business is using more debt to finance assets and operations, and will eat away at profitability — which could indicate that it’s on shaky financial footing. Conversely, a lower ratio typically shows a company with low financial risk and less risk to lenders and investors.

These ratios are also an important metric for shareholders and management to understand their financial obligations and the sweet spot for high leverage. Because debt borrowing can improve shareholder returns, shareholders may be pleased to learn your organization is operating with a reasonable degree of leverage.

Management, of course, can use its understanding of leverage ratios to make critical decisions about the amount of debt the company is carrying and whether any adjustments need to be made to lower risk or increase debt to grow or make new investments.

What are the common types of leverage ratios?

The various leverage ratios available can offer different insights depending on what you’re looking to measure.

These are the most commonly used leverage ratios:

Debt ratio or Debt to assets ratio: Total debt-to-total-asset is calculated as total borrowings divided by total assets. Measures the percent of assets that are being financed with borrowings.

Debt to equity ratio: Calculated as total borrowings divided by shareholder equity. Measures the weight of borrowings against shareholder equity.

The debt to capital ratio: Calculated by dividing a company's total debt by its total capital, which is total debt plus total shareholders' equity.

Interest coverage ratio: Calculated as EBIT (Earnings Before Interest and Tax) divided by interest. Measures how many times the company can cover interest expense out of earnings.

Debt to EBITDA ratio or operating leverage ratio: (Earnings before interest, tax, depreciation, and amortization) ratio: Calculated as debt divided by EBITDA. Measures the amount of earnings that is available to payback debt before paying interest and tax.

How to use these ratios for maximum value

Understanding leverage ratios provides critical insights into the financial health of your business. Although it can be useful to calculate these ratios on their own, they can deliver much more meaningful insights when tracked and studied as a group over time so you can determine if higher returns can be achieved with or without higher leverage ratios.

Phocas Financial Statements allows you to customize your income statements and balance sheet and add in custom calculations, such as debt-to-assets ratio and debt to EBIDTA ratio.

You can line these metrics up side by side and select a monthly view to observe the trends over time. Additionally, you can compare a data set to another period of your choosing helping to communicate the company’s ability to service the company’s debt. As your numbers shift in real-time, the data in the financial statement updates automatically — unlike in static reporting, where you’d have to make the changes manually to see the changes in interest payments or debt obligations.

Knowing your company’s financial leverage ratios helps you determine how much debt your company is carrying and how much wiggle room you have — in other words, how much debt you can continue to take on and still meet the terms of your financial covenants.

To learn more about how Phocas’s financial solutions can maximize the value of your company's financial ratios, download the ebook below