What Is a Financial Leverage Ratio?

Introduction

A financial leverage ratio is a metric used to assess a business’s financial stability and solvency by estimating the amount of debt a business has in relation to its assets. It is an indication of a company’s ability to service its debt and meet financial obligations.

Understanding financial leverage ratio is important for investors, creditors and debtors to gain a better understanding of the company’s cash flow, debt structure and risk of default. A higher financial leverage ratio suggests that a company is loaded with debt, making it a riskier investment. Similarly, a low financial lever ratio suggests a lack of investor confidence in the company.

Types of Financial Leverage Ratios

Debt to Equity Ratio

The debt to equity ratio, also known as the liability to net worth ratio, is a measure of the financial leverage of a business. It is calculated by dividing the total liabilities of a company by its total shareholder equity. The debt to equity ratio is seen as a measure of a company’s financial risk. A high debt to equity ratio generally indicates that a company is relying heavily on borrowed money, which increases its vulnerability to financial stress.

Interest Coverage Ratio

The interest coverage ratio is a financial leverage ratio that measures the ability of a business to pay its interest expenses. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses for a given period of time. A low interest coverage ratio means that a company is not generating enough income to cover its interest obligations, which puts it under greater risk of defaulting on its debt.

Debt Service Coverage Ratio

The debt service coverage ratio (DSCR) is a financial leverage ratio that indicates a company’s ability to pay off its debt obligations. It is calculated by dividing a company’s net operating income (NOI) by the total amount of its debt service obligation (principal and interest payments). A high DSCR indicates that a company is in a strong position to pay off its debts and has a good chance of obtaining additional financing. A low DSCR may signal that a company could be at risk of defaulting on its debt.

Debt to Equity Ratio Explained

The debt to equity ratio is a financial leverage ratio and one of the most widely used indicators of a company's financial strength and overall health. This ratio gives an idea of how much money a company needs to borrow to purchase and operate its assets. The higher the ratio, the more debt a company has.

Definition

The debt to equity ratio is a calculation that compares a company's total liabilities to its total equity. This is expressed as a ratio or percentage. A higher number indicates that a company has a greater amount of debt compared to its equity. To put it simply, this ratio tells you the extent to which a company relies on creditors for financing instead of its own equity.

Calculation

The debt to equity ratio is calculated by dividing the total liabilities of a company by its total equity. This ratio can be expressed as a percentage, as a ratio, or as a number. Here is the formula to calculate the ratio:

• Debt to Equity Ratio = Total Liabilities / Total Equity

Example

For example, if a company has total liabilities of $2 million and total equity of $3 million, then the debt to equity ratio would be calculated as follows:

• Debt to Equity Ratio = $2 million / $3 million = 0.67

This shows that the company has a debt to equity ratio of 0.67 or 67%. This means that the company has borrowed $2 million from creditors to purchase and operate its assets, and it has $3 million in equity to cover these debts. This ratio provides important insight into the financial health of a company.

Interest Coverage Ratio Explained

Interest coverage ratio is a measure of a company’s ability to pay the interest expense on its debt. The ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its total interest expense for a certain period of time. A higher ratio is better as it indicates a better ability to pay the interest expenses.

Definition

The interest coverage ratio is defined as a measure of a company’s ability to pay the interest expense on its debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its total interest expense for a certain period of time.

Calculation

The interest coverage ratio is calculated by dividing EBIT (earnings before interest and taxes) by the total interest expenses for a certain period of time. The formula is as follows:

Interest Coverage Ratio = EBIT / Total Interest Expense

Example

For example, if a company has EBIT of $100,000 and its interest expense for the period of time is $20,000, its interest coverage ratio is 5.0 ($100,000 / $20,000 = 5.0). This indicates that the company has a good ability to pay the interest expense on its debt.

Debt Service Coverage Ratio Explained

The debt service coverage ratio is a financial lever ratio that measures a company or individual’s ability to pay its debt obligations. By comparing the net operating income to required debt payments on a given property, the debt service coverage ratio measures the amount of cash flow available to cover these obligations. Generally speaking, the higher the debt service coverage ratio, the greater the borrower's ability to pay down debt.

Definition

Debt service coverage ratio is typically a lender’s measure of the borrower’s ability to service particular debt. It is known as the debt service coverage ratio (DSCR) or debt coverage ratio (DCR). It is calculated by taking the property’s net operating income (NOI) divided by the total debt service. A property with a debt service coverage ratio of 1.2 or greater is usually considered acceptable by most lenders.

Calculation

In order to calculate the debt service coverage ratio, you’ll need the following three pieces of information: NOI (net operating income), Debt Service (mortgage payments), and Vacancy and Collection Losses. Vacancy and collections losses refer to income you may be missing out because of unoccupied units, tenants who are behind on their rent, and other similar losses.

• NOI: Add the following: Gross Rental Income (minus) Expenses (leasing and property management expenses, utilities, taxes, insurance, normal repairs and maintenance).
• Debt Service: Add all mortgages, liens and lines of credit payments and costs.
• Vacancy and Collection Losses: Add up any money you may be missing out on because of unoccupied units, and tenants who are behind on rent.

Once you have all of this information, you can calculate the debt service coverage ratio by dividing the NOI by the debt service plus vacancy and collection losses. For example, if your NOI is $10,000 and your debt service is $8,000, your debt service coverage ratio would be 1.25 ($10,000/$8,000). This shows that your property has sufficient cash flow to cover its debt obligations.

Example

Let’s say a company has an NOI of $20,000, debt service of $10,000, and a vacancy and collection loss of $4,000. In this case, their DSCR would be 2.00 ($20,000/$10,000 + $4,000). This shows that the company’s cash flow is double the amount of its debt obligations. This would be viewed as a strong ratio by lenders and increase a borrower's chances of getting approved for a loan.

Conclusion

The knowledge of financial leverage ratios is of critical importance to individuals, businesses, and investors. It allows users to measure their financial risk in terms of capital structure, easily calculate debt to equity, and recognize their operational efficiency. Knowing this information will allow individuals to make informed decisions, businesses to understand their strengths and weaknesses, and investors to identify undervalued businesses or investments.

Financial leverage ratio is a useful way to gain an understanding of a company's financial position and its ability to generate return on equity. It offers a reliable measure of the company’s financial leverage, efficiency, and long-term survival capabilities. Thus, an understanding of financial leverage ratios can play a key factor in determining whether an investment is worthy of consideration.

Importance of Understanding Financial Leverage Ratios

By understanding and appropriately utilizing financial leverage ratios, businesses can gain a strong perspective on their debt-to-equity ratio, profitability, and other key financial ratios. With this information, businesses and investors can adjust their strategies to ensure the best possible outcomes. Companies can also use it to identify areas of growth, as well as potential weaknesses that need to be addressed. Finally, investors can use financial leverage ratios to determine the level of risk they are willing to take on an investment.

Conclusion

Financial leverage ratios are used to determine the amount of debt, and with it, the associated risk in a company. These ratios help to evaluate a company’s financial health by gauging its ability to meet its obligations. Along with other measures such as profitability and current ratios, financial leverage ratios can provide useful insights into a company’s finances and its risk profile.

Resources

Websites

• Investopedia: What is a Financial Leverage Ratio?
• My Accounting Course: Leverage Ratios
• CFI: Financial Leverage Ratio

Books

• Fabozzi, Frank J.,Tiasa C. Mohanty and William F. Channell. 2011. The Handbook of Financial Instruments. London: John Wiley & Sons
• Fabozzi, Frank J., Thomas M. Quigley and Lorie N. Allan. 2007. Fixed Income Mathematics: Analytical and Statistical Techniques. London: John Wiley & Sons
• Elton, Edwin J., Martin J. Gruber, Stephen J. Brown and William N. Goetzmann.2013. Modern Portfolio Theory and Investment Analysis. New York: John Wiley & Sons