Leverage Ratio: What It Means and How to Calculate It

Leverage Ratio ; Operating Leverage Ratio · Operating Leverage Ratio = % change in EBIT (earnings before interest and taxes) / % change in sales. Sales|5minread LeverageRatio:WhatItMeansandHowtoCalculateIt WrittenbyJayFuchs @Jay_Fewks Securingfundingisatallorderforanybusiness.Friends,family,venturecapitalfirms,andbanksallhavetheirshareofstandards,expectations,andskepticismwhenitcomestodolingoutmoney.Ifyou'reinthethickofthatprocess,youneedtohaveagrasponsomekeymetricsandstickingpoints—oneofthembeingsomethingknownasyourleverageratio. Here,we'llexploretheconceptabitfurther,reviewsomeoftheratiosthatfallunderthebroader"leverageratio"umbrella,seewhatasolidonelookslike,andtakealookatsomeexamples.Let'sjumpin. LeverageRatio Theterm'leverageratio'referstoasetofratiosthathighlightabusiness'sfinancialleverageintermsofitsassets,liabilities,andequity.Theyshowhowmuchofanorganization'scapitalcomesfromdebt—asolidindicationofwhetherabusinesscanmakegoodonitsfinancialobligations. Ahigherfinancialleverageratioindicatesthatacompanyisusingdebttofinanceitsassetsandoperations—oftenatelltalesignofabusinessthatcouldbeariskybetforpotentialinvestors. Itcanmeanthatearningswillbeinconsistent,itcouldbeawhilebeforeshareholderscanseeameaningfulreturnontheirinvestment,orthebusinesscouldsoonbeinsolvent. Creditorsalsorelyonthesemetricstodeterminewhethertheyshouldextendcredittobusinesses.Ifacompany'sfinancialleverageratioisexcessive,itmeansthey'reallocatingmostofitscashflowtopayingoffdebtsandismorepronetodefaultingonloans. Alowerfinancialleverageratioisusuallyamarkofafinanciallyresponsiblebusinesswithasteadyrevenuestream.Evenifacompanybehinditisrunningsignificantdebts,anexceptionalfinancialleverageratiotellspotentialshareholdersandcreditagenciesthatabusinessposesminimalriskandislikelyworthaninvestment. Whatisagoodfinancialleverageratio? Anidealfinancialleverageratiovariesbythetypeofratioyou'rereferencing.Withsomeratios—liketheinterestcoverageratio—higherfiguresareactuallybetter.Butforthemostpart,lowerratiostendtoreflecthigher-performingbusinesses. Forinstance,withthedebt-to-equityratio—arguablythemostprominentfinancialleverageequation—youwantyourratiotobebelow1.0.Aratioof0.1indicatesthatabusinesshasvirtuallynodebtrelativetoequityandaratioof1.0meansacompany'sdebtandequityareequal.Inmostcases,aparticularlysoundonewillfallbetween0.1and0.5. Aratioof0.5—anindicationthatabusinesshastwiceasmanyassetsasithasliabilities—isconsideredtobeonthehigherboundaryofdesirableandrelativelycommon.Thatsaid,whatcanbeconsidereda"common"figurevariesfromcasetocase,accordingtofactorslikeacompany'sscale,maturity,andindustry. BusinessesWithHigherLeverageRatios Atypicalstartupoftenhastoincursignificantdebtstogetoffthegroundandallocateasignificantportionofitscashflowtosettlethem—makingforhigherfinancialleverageratios.Businesseswithhigherproductioncostsalsotendtorunhigherdebt-to-equityratiosthanmostothers. Beyondthat,certainindustrieslendthemselvestohigheraveragefinancialleverageratios.Inthosecases,youcangaugethesoundnessofacompany'sfinancialleveragebycomparingittothoseofitscompetitors. Forexample,businessesincapital-intensiveindustries—likeoilandgasortelecommunications—oftenhavetosinksignificantfinancialresourcesintoinfrastructureandmaintenance,makingforlargeinvestmentsthatcaninflatedebt-to-equityfigures. HowtoCalculateLeverageRatio Thereareafewdifferenttypesofleverageratiosthatfallunderthe"financialleverageratio"umbrella.Here'showtocalculatethreeofthem,usingdatafoundonyourbalancesheetorgeneralledger: OperatingLeverageRatio Operatingleverageratiomeasurestheratioofabusiness'contributionmargintoitsnetoperatingincome.Itevaluateshowmuchabusiness'incomechangesrelativetochangesinsales.It'scalculatedusingthefollowingformula: OperatingLeverageRatio=%changeinEBIT(earningsbeforeinterestandtaxes)/%changeinsales NetLeverageRatio Netleverageratio,ornetdebttoEBITDA(earningsbeforeinterest,taxes,depreciation,andamortization)measurestheratioofabusiness'debttoearnings.ItreflectshowlongitwouldtakeabusinesstopaybackitsdebtifdebtandEBITDAwereconstant.It'scalculatedusingthefollowingformula: NetLeverageRatio=(NetDebt-CashHoldings)/EBITDA Debt-to-EquityRatio Debt-to-equityratiomeasurestheratioofabusiness'totalliabilitiestoitsstockholders'equity.Itoffersanat-a-glancelookatthevalueofabusinessrelativetoitsdebts.It'scalculatedusingthefollowingformula: Debt-to-EquityRatio=Liabilities/Stockholders'Equity FinancialLeverageRatioExamples Herearesomeexamplesofwhatfinancialleverageratioscanlooklikeinpractice. Apple's2021Debt-to-EquityRatio ImageSource:MacroTrends ThoughApple'scurrentdebt-to-equityratioisabove1.0,bynomeansisitunmanageableoralarming.Plus,it'sApple—shareholdersprobablyaren'ttooworriedaboutthecompany'sliabilitiesgettingoutofcontrol.  Verizon's2015Debt-to-EquityRatio ImageSource:MacroTrends In2015,Verizonmadesomesizableinvestments—includingallocating$28billionforspectrumlicensesandcapitalforfuturenetworkcapacity—thattookasignificantinitialtollonstockholders'equitywhileaddingtoitsdebt,leadingtoaninflateddebt-to-equityratio.However,oncethoseinvestmentsstartedpayingoff,Verizon'sfinancialleverageratioleveledoutandreturnedtoalower,morereassuringfigure. Ifyou'relookingtosecurefundingorjustwantabetterunderstandingofhowyourbusinessmightfaregoingforward,it'simportantyouhaveagrasponyourleverageratios.Thesefigurescanbeverytellingintoyourcompany'shealth,potential,andabilitytodeliveronitsfinancialobligations. Editor'snote:ThispostwasoriginallypublishedinNovember,2018andhasbeenupdatedforcomprehensiveness.   OriginallypublishedJul15,20211:00:00PM,updatedJuly152021 Topics: Entrepreneurship Don'tforgettosharethispost! RelatedArticles Outsourcing:Pros,Cons,&ProjectstoConsiderWhenHiringaThirdParty Sales  |7minread The7KeyQualitiesThatDefinetheEntrepreneurMindset Sales  |11minread 12SideHustleIdeasforFull-TimeEntrepreneursandSalesPros Sales  |4minread ExpandOffer ctaSalesPlanTemplate Getitnow Getitnow DownloadforLater