Leverage Ratio: Definition, Importance, Types with Formula, Example, Limitations

Leverage ratios are important financial metrics that provide insights into a company’s capital structure, debt levels, and ability to meet financial obligations. Leverage ratios help assess the balance between risk and return in a company’s operations by measuring how much debt is used relative to equity. Common leverage ratios analyzed by investors include the debt-to-equity ratio, interest coverage ratio, and debt-to-EBITDA ratio.

The debt-to-equity ratio compares a company’s total liabilities to its shareholders’ equity, indicating how aggressively it is financed through debt. The interest coverage ratio assesses the firm’s earnings cushion for debt payments. The debt-to-EBITDA ratio measures how many years it would take for operating cash flows to pay off debt obligations. By analyzing these ratios, investors can identify red flags like excessive leverage that increases insolvency risks, especially during economic downturns.

Leverage also impacts other factors like credit ratings, liquidity, flexibility, and earnings volatility. Prudent use of debt can magnify returns when times are good, but high leverage burdens companies with large interest costs and leaves little room for error if conditions worsen. Therefore, leverage ratios are an important tool for fundamental analysis, allowing investors to evaluate capital structure risks and gauge the stability of a company’s finances.

What are leverage ratios?

Leverage ratios are financial metrics that measure a company’s ability to meet its debt obligations. Leverage ratios are important indicators of a company’s financial health and stability. A high leverage ratio means a company has taken on significant debt relative to its equity or assets. This makes the company riskier for investors, as high debt levels mean the company must direct more cash flow to make interest payments rather than investing for growth.

However, leverage also boosts returns for shareholders when times are good. So leverage is a double-edged sword. Common leverage ratios used by investors and analysts include the debt-to-equity ratio, interest coverage ratio, and debt-to-EBITDA ratio. These track how much debt a company has compared to the size of its balance sheet and earnings. Highly leveraged companies generally have a higher risk of default, especially in economic downturns. So, wise investors keep an eye on leverage ratios to gauge the financial risks and potential rewards of investing in a particular stock.

Why is it important to know leverage ratios?

Leverage ratios are important for stock market investors to analyze because they indicate a company’s ability to meet its financial obligations and provide insights into its risk profile, valuation, cost of capital, management strategy, and financial flexibility.

Leverage ratios assess solvency risk. Highly leveraged companies have heavy debt burdens and face greater risk of default, especially in downturns. The higher a company’s leverage, the greater the chance it struggles to repay debts. Common leverage ratios like debt-to-equity and debt-to-EBITDA highlight when a company’s debt load is excessive or difficult to service based on its assets and earnings.

Leverage impacts valuations and shareholder returns. Increased financial leverage magnifies returns for shareholders when times are good. However, it also magnifies losses when conditions deteriorate. Investors must weigh the potential risks and rewards of leverage in their analysis. Comparing leverage ratios helps determine if a company’s capital structure enhances or threatens shareholders’ interests. 

Leverage affects credit ratings and the cost of capital. High leverage raises red flags for credit ratings agencies. It increases a company’s risk of default and results in higher borrowing costs. But prudent use of leverage lowers a firm’s overall cost of capital. Analyzing leverage ratios helps investors gauge the effect of debt on a company’s credit profile and funding costs.

Leverage signals management’s appetite for risk. Aggressive managers push leverage to potentially unsustainable levels. More conservative managers maintain lower, safer leverage ratios. Leverage ratios provide clues into management’s philosophy and strategy regarding financial risks. Wise investors favour prudent leverage policies that align with their own risk preferences.

Leverage ratios inform judgments of financial flexibility. Companies with low leverage and strong balance sheets have greater flexibility to pursue investments and strategic options. Firms saddled with high debt burdens lose financial flexibility. Leverage ratios help investors discern a company’s ability to adapt and take advantage of future opportunities.

What are the types of leverage ratios used in ratio analysis?

The most common leverage ratios used in ratio analysis of stocks are the debt-to-equity ratio which measures a company’s financial leverage by dividing its total debt by shareholders’ equity, the debt-to-capital ratio that shows the percentage of a company financed by debt by dividing total debt by total capital, and the interest coverage ratio which gauges a company’s ability to pay interest expenses based on its earnings by dividing EBIT or earnings before interest and taxes by the company’s interest expenses.

1.Debt ratio

The debt ratio, also called the debt-to-assets ratio, measures the amount of debt a company has relative to its total assets. It shows what proportion of assets is financed through debt versus equity. 

Formula: Debt Ratio = Total Liabilities / Total Assets

For example, a company has Rs. 2 million in total liabilities and Rs. 5 million in total assets. Its debt ratio is as stated below.

Debt Ratio = Rs. 2 million / Rs. 5 million = 0.4

This means 40% of the company’s assets are financed through debt.

The debt ratio is an important ratio for stock market investors to assess the financial leverage and solvency of a company. A high debt ratio indicates the company is aggressive in financing through debt and has higher financial risk. For industries like utilities or real estate, a debt ratio of 0.5 is sometimes acceptable. But for most companies, investors prefer a debt ratio below 0.4.

A rising debt ratio over time signals that a company is having difficulty meeting debt obligations or taking on excessive leverage. This sometimes makes its stock riskier. On the other hand, a declining debt ratio shows the company is reducing leverage and becoming financially healthier. Investors examine the debt ratios of similar firms when assessing equities and keep an eye out for long-term trends. The debt ratio helps determine if a company’s capital structure properly balances financial risk versus return.

2. Debt to asset ratio

The debt to asset ratio measures the proportion of a company’s assets that are financed through debt. It indicates the degree of leverage being used to finance the company’s operations.

Formula: Debt to Asset Ratio = Total Liabilities / Total Assets

For example, a company has Rs. 2 million in total liabilities and Rs. 5 million in total assets. Its debt to asset ratio is as stated below.

Debt to Asset Ratio = Rs. 2 million / Rs. 5 million = 0.4 

This means 40% of the company’s assets are financed through debt.

The debt to asset ratio is an important metric for stock investors to gauge a company’s financial risk. A high ratio over 0.5 indicates the company is highly leveraged. This makes it riskier if business conditions deteriorate. Investors typically prefer low debt to asset ratios below 0.4. 

Trends in the ratio over time also provide insight. A rising debt to asset ratio could signal a company has too much debt and is overleveraged. This negatively impacts its stock price. Meanwhile, a declining ratio suggests the company is reducing leverage and becoming financially healthier. Comparing debt to asset ratios between companies in the same industry also helps investors evaluate financial risk. The debt to asset ratio helps determine if a company’s capital structure properly balances risk and supports stability.

3. Debt to equity ratio

The debt to equity ratio measures the relationship between a company’s total liabilities and shareholders’ equity. It indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.

Formula: Debt to Equity Ratio = Total Liabilities / Shareholders’ Equity 

For example, a company has Rs. 2 million in total liabilities and Rs. 5 million in shareholders’ equity. Its debt to equity ratio is as stated below.

Debt to Equity Ratio = Rs. 2 million / Rs. 5 million = 0.4

This means for every Rs. 1 of equity, the company has Rs. 0.40 of debt. 

The debt to equity ratio is an important metric for stock investors to assess a company’s financial leverage and risk. A high ratio over 1.0 indicates high financial leverage. This means the company is funding more of its operations through debt versus equity financing. Highly leveraged companies carry more risk of insolvency if business conditions decline. Investors typically prefer low debt to equity ratios below 1.0.

Trends in the ratio also provide insight. A rising debt to equity ratio over time could foreshadow trouble meeting debt payments down the road. Meanwhile, a declining ratio suggests the company is reducing leverage and risk. Comparing debt to equity ratios between companies in the same industry helps investors evaluate financial risk. The debt to equity ratio indicates the balance between debt and equity financing and associated risks.

4. Debt to capital ratio

The debt to capital ratio measures the proportion of a company’s capital structure that is financed by debt versus equity. Capital structure refers to the mix of debt and equity used to finance a company’s operations and growth. 

Formula: Debt to Capital Ratio = Total Debt / (Total Debt + Shareholders’ Equity)

For example, a company has Rs. 2 million in total debt and Rs. 5 million in shareholders’ equity. Its debt to capital ratio is as stated below.

Debt to Capital Ratio = Rs. 2 million / (Rs. 2 million + Rs. 5 million) = 0.29

This means 29% of the company’s capital structure is debt, while 71% is equity.

The debt to capital ratio helps stock investors assess a company’s financial leverage and stability. A high ratio over 0.6 indicates high dependency on debt financing which increases financial risk. Companies with high debt to capital ratios are vulnerable if business conditions decline. Investors typically prefer low ratios below 0.4. 

Looking at trends in the ratio provides insight into changing risk profiles. A rising debt to capital ratio suggests a company is taking on more financial leverage and risk. A declining ratio indicates decreasing dependency on debt financing. Comparing debt to capital ratios between companies in the same sector also helps investors evaluate risk levels. Overall, the debt to capital ratio shows the balance of financial leverage and helps determine the soundness of a company’s capital structure.

5. Debt to EBITDA ratio

The debt to EBITDA ratio measures a company’s debt relative to its earnings before interest, taxes, depreciation, and amortization (EBITDA). It assesses the ability to pay off debt obligations from operating cash flow. 

Formula: Debt to EBITDA Ratio = Total Debt / EBITDA

For example, a company has Rs. 20 million in total debt and Rs. 10 million in EBITDA. Its debt to EBITDA ratio is as stated below.

Debt to EBITDA Ratio = Rs. 20 million / Rs. 10 million = 2.0

This means the company’s debt is 2 times its annual EBITDA.

The debt to EBITDA ratio helps stock investors gauge a company’s financial leverage and ability to service debt. A high ratio over 5.0 indicates high financial risk and difficulty meeting obligations. Investors prefer low ratios below 3.0.

Looking at trends provides insight. A rising debt to EBITDA ratio suggests increasing reliance on debt and deteriorating ability to make payments. A declining ratio indicates reduced leverage and improving cash flows to service debt. Comparing debt to EBITDA ratios between industry peers also evaluates relative risk levels. Overall, the debt to EBITDA ratio assesses the sustainability of a company’s capital structure and associated risks for stock investors.

6. Asset to equity ratio

The asset to equity ratio measures the proportional amount of assets to shareholder equity in a company. It is calculated by dividing total assets by total shareholders’ equity. 

Formula: Asset to Equity Ratio = Total Assets / Shareholders’ Equity

For example, a company A has Rs. 2 million in total assets and Rs. 1 million in shareholders’ equity. Its asset to equity ratio is as stated below.

Rs. 2,000,000 / Rs. 1,000,000 = 2

This means for every Rs. 1 of equity, Company A has Rs. 2 in assets. 

The asset to equity ratio is an important ratio in fundamental stock analysis. It shows the degree of financial leverage and long-term solvency of a company. Investors look at this ratio to determine how risky a stock is and how capable the company is at meeting its debt obligations.

A higher asset to equity ratio indicates the company is relying heavily on debt financing and has higher financial leverage. This makes the company riskier for stock investors. A lower ratio indicates the company is financing itself more through equity rather than debt. This is generally considered less risky for stockholders.

Comparing asset to equity ratios over time or between companies in the same sector provides insights into their relative financial leverage and solvency. Investors typically prefer stocks with lower asset to equity ratios as they represent less financial risk. However, higher leverage also means higher returns if managed properly. 

7. Equity ratio

The equity ratio measures the proportion of total assets financed by shareholders’ equity. It is calculated by dividing shareholders’ equity by total assets.

Formula: Equity Ratio = Shareholders’ Equity / Total Assets

For example, a company B has Rs. 500,000 in shareholders’ equity and Rs. 2,000,000 in total assets. Its equity ratio is as stated below.

Rs. 500,000 / Rs. 2,000,000 = 0.25

This means 25% of Company B’s assets are financed through equity.

The equity ratio helps investors assess the riskiness and financial leverage of a company. A higher equity ratio indicates less financial leverage, meaning the company relies more on equity financing rather than debt. This signals lower risk for shareholders.

A lower equity ratio means the company uses more debt financing to fund growth. While this means higher potential returns, it also exposes shareholders to higher risk if the company cannot meet debt obligations.

Investors use the equity ratio to screen for stocks with strong balance sheets and lower financial risks. Comparing the ratio over time shows the changing capital structure of a company. Analysts view an increasing equity ratio as the company maturing and lowering risk. A declining ratio indicates higher risk from increasing debt levels.

The equity ratio provides important insights into financial strength and leverage when analyzed alongside other financial metrics and ratios. As with any single ratio, it should not be used alone to evaluate investment potential. It is one useful tool in conducting thorough fundamental analysis on stocks.

8. Equity multiplier ratio

The equity multiplier ratio measures the amount of assets financed by each rupee of shareholder equity. It is calculated by dividing total assets by shareholders’ equity. 

Formula: Equity Multiplier = Total Assets / Shareholders’ Equity

For example, a company C has Rs. 3 million in total assets and Rs. 1 million in shareholders’ equity. Its equity multiplier is as stated below.

Rs. 3,000,000 / Rs. 1,000,000 = 3

This means for each Rs. 1 of equity, Company C finances Rs. 3 in assets. 

The equity multiplier ratio helps investors assess financial leverage and risk. A higher ratio indicates greater financial leverage, meaning more assets are funded through debt rather than equity.

While higher leverage boosts returns, it also exposes shareholders to higher risk if the company cannot meet debt payments. A lower equity multiplier signals the company relies less on debt financing.

Investors use this ratio to screen for stocks with strong balance sheets and lower financial risk. Comparing the ratio over time or between peers shows the changing capital structure and risk profile of a company.

A rising equity multiplier indicates a company is taking on more debt and increasing risk. A declining ratio suggests decreasing financial leverage and risk. The equity multiplier provides important insights into leverage and risk when used together with other financial ratios in thorough stock analysis.

9. Degree of financial leverage

The degree of financial leverage measures the sensitivity of a company’s earnings per share to changes in operating income, based on its capital structure. It shows how the use of debt financing amplifies returns. 

Formula: Degree of Financial Leverage = % Change in Earnings Per Share / % Change in Operating Income

For example, company A has Rs. 100,000 in operating income this year and Rs. 50,000 in interest expense on debt. With 100,000 shares outstanding, EPS is Rs. 0.50 (Rs. 100k – Rs. 50k interest / 100k shares). The following year’s EPS would grow by 20% to Rs. 0.60 if operating income increased by 10% to Rs. 110,000 and interest remained the same.

The DFL is 20% / 10% = 2X

Investors use DFL to evaluate how the use of debt by a company positively leverages returns during growth periods but also introduces risk. A higher DFL indicates greater sensitivity of earnings to operating income changes.

Analysts look at DFL trends over time to assess changes in financial risk. Increasing DFL means greater leverage and upside earnings potential, but also higher risk if operating income declines. Declining DFL suggests the company is relying less on debt financing.

DFL helps quantify the risk-reward tradeoff of debt financing. Used with other ratios like debt-to-equity, it provides insights into a company’s capital structure and potential stock volatility.

10. Consumer leverage ratio

The consumer leverage ratio measures the ratio of total debt payments for consumers relative to disposable income. It gauges consumers’ ability to manage debt loads. 

Formula: Consumer Leverage Ratio = Total Consumer Debt Payments / Disposable Personal Income

For example, the consumer leverage ratio is as follows, assuming that consumers have Rs. 1 trillion in total debt payments and Rs. 10 trillion in disposable income.

Rs. 1 trillion / Rs. 10 trillion = 0.10

This means consumer debt payments represent 10% of disposable income.

The consumer leverage ratio is an important indicator of economic health. Analysts monitor trends in this ratio to assess consumer financial stress. A rising ratio means consumers are taking on more debt relative to income, signalling potential reductions in consumer spending that could negatively impact stocks.

A high and increasing consumer leverage ratio is a warning sign of potential economic downturn. As consumers spend more of their income servicing debt, they have less left for discretionary purchases. This reduces revenues and profits for consumer dependent sectors.

On the other hand, a declining ratio suggests consumers are able to take on more sustainable debt loads, supporting continued consumer spending and a healthy economy. Analyzed together with other macroeconomic indicators, the consumer leverage ratio provides insights into consumer health and associated risks and opportunities across stock sectors.

11. Debt to EBITDA ratio

The debt to EBITDA ratio measures a company’s ability to pay off its debt obligations from its earnings before interest, taxes, depreciation, amortization, and exploration expenses (EBITDAX). 

Formula: Debt to EBITDAX Ratio = Total Debt / EBITDAX 

Where total debt includes short-term and long-term debt obligations. EBITDAX adds back exploration expenses to EBITDA to provide a better measure of cash flow for oil and gas companies. 

For example, a company’s debt to EBITDA ratio would be 5 (Rs. 100 million / Rs. 20 million) if it had Rs. 100 million in total debt and Rs. 20 million in EBITDAX.

The debt to EBITDA ratio is an important metric in the stock market to assess an oil and gas company’s financial health and ability to service its debt. A lower ratio indicates the company is less leveraged and has more cushion to pay off debt. A higher ratio means the company is highly leveraged and has trouble meeting debt obligations.

Investors compare debt to EBITDA ratios over time to see if a company’s financial position is improving or deteriorating. They also compare ratios across industry peers to gauge which companies have healthier balance sheets. A ratio under 3x is generally considered prudent in the oil and gas industry.

The debt to EBITDA ratio is useful for stock market analysis because it focuses specifically on a company’s operating cash flows from which debt will be repaid, rather than just earnings. By adding back exploration costs, it provides a more realistic picture for capital intensive oil and gas companies. Evaluating this leveraging metric helps investors assess credit risk and weigh company valuations in the stock market.

12. Interest coverage ratio

The interest coverage ratio measures how easily a company pays its interest expenses on outstanding debt. 

Formula: Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

For instance, a company’s interest coverage ratio is 4 (Rs. 20 million / Rs. 5 million) if its EBIT is Rs. 20 million and its interest expenditure is Rs. 5 million. 

The interest coverage ratio is an important metric in the stock market for assessing a company’s financial health and creditworthiness. A higher ratio indicates the company is more easily able to meet interest obligations. A lower ratio sometimes suggests the company has excessive debt and difficulty servicing it. 

Investors use the interest coverage ratio to evaluate earnings quality and the risk of bankruptcy or default. It provides an indication of how much earnings are burdened by interest expenses. Comparing interest coverage ratios over time shows whether a company’s financial cushion is improving or worsening.

Investors also benchmark a company’s ratio against industry averages or competitors. Typically a ratio above 3x is considered financially healthy. The ratio sometimes indicates trouble and an inability to make debt payments if it drops below 1.5x.

By revealing the company’s debt servicing ability, the interest coverage ratio helps investors assess credit and bankruptcy risk. It is a useful tool for stock market analysis to weigh leverage, earnings quality, and downside risk. Monitoring this metric over time and against peers gives key insights into financial flexibility and safety.

13. Fixed charge coverage ratio

The fixed charge coverage ratio measures a company’s ability to cover fixed expenses like debt payments, interest, leases, and rent. 

Formula: Fixed Charge Coverage Ratio = Earnings Before Interest, Taxes, Depreciation, Amortisation (EBITDA) / Fixed Charges

Fixed charges include interest, debt repayments, leases, and rent expenses. 

For instance, a company’s fixed charge coverage ratio is 4 (Rs. 20 million / Rs. 5 million) if its EBITDA is Rs. 20 million and its fixed charges are Rs. 5 million.

The fixed charge coverage ratio is an important metric in the stock market for gauging a company’s financial flexibility. A higher ratio indicates more cushion to cover fixed obligations. A lower ratio suggests tight margins and risk of default.

Investors use this ratio to assess bankruptcy risk, earnings quality, and a company’s ability to take on more debt. It provides insights into financial safety and stability.

Comparing the fixed charge coverage ratio over time shows whether financial health is improving or worsening. Benchmarking against industry averages indicates relatively strong or weak financial standing. A ratio above 3x is generally favourable. Below 1x indicates high distress risk.

By revealing fixed payment burdens, the fixed charge coverage ratio helps investors evaluate leverage, credit risk, and earnings quality. Monitoring this metric and trends provides key insights into financial flexibility and downside risk. 

14. Capital gearing ratio

The capital gearing ratio measures the degree of a company’s leverage by comparing its debt financing relative to equity financing. 

Formula: Capital Gearing Ratio = Debt / (Debt + Equity)

A company’s capital gearing ratio, for instance, would be 0.33 (Rs. 50 million / (Rs. 50 million + Rs. 100 million)) if it had Rs. 50 million in debt and Rs. 100 million in equity.

This ratio is useful in the stock market for gauging financial risk and stability. A higher ratio indicates greater leverage and financial risk, as the company is funding more of its assets through debt. A lower ratio suggests lower risk as assets are more funded through shareholders’ equity.

Investors compare gearing ratios over time to assess changes in leverage and risk profile. Comparing ratios across industry peers also reveals relative financial risk. Typically a ratio of 0.5 or lower is preferable. Above 0.7 indicates high leverage and risk.

By analyzing debt levels relative to equity, the capital gearing ratio helps investors evaluate financial leverage, stability, and downside risk. A company with high gearing sometimes experiences greater volatility in earnings and cash flows as interest expenses rise. 

Monitoring this metric provides insights into how risky the capital structure is. Rapidly rising leverage could signal potential financial distress. The gearing ratio is an important tool for weighing risk-reward tradeoffs in stock market analysis.

15. Operating leverage ratio

The operating leverage ratio measures the degree to which a company increases operating income by increasing revenue sales volume. 

Formula: Operating Leverage Ratio = Percentage Change in Operating Income / Percentage Change in Sales

The operational leverage ratio, for instance, would be 2 (10% / 5%) if operating income grew by 10% and sales climbed by 5%. 

This ratio shows how sensitive operating income is to fluctuations in sales volume. A higher ratio indicates greater operating leverage, meaning larger swings in operating earnings from changes in sales.

Investors use this ratio to gauge business risk and sensitivity to economic cycles. Companies with higher operating leverage see amplified gains in upmarkets but also greater declines in downturns.

Comparing operating leverage ratios over time shows if a company’s risk profile is increasing or decreasing. Benchmarking against industry peers indicates relatively higher or lower business risk.

By revealing operating sensitivity, this ratio helps investors assess earnings volatility and downside potential. High operating leverage magnifies gains but also losses. Monitoring this metric provides insights into sensitivity to economic swings.

The operating leverage ratio is an important analytical tool in stock market analysis for weighing a company’s business risk and volatility profile. Investors use it to gauge earnings fluctuations through business cycles.

16. Financial leverage ratio

Financial leverage ratio measures how much debt a company uses to finance its assets. The two main types are debt ratio and debt-to-equity ratio. 

Formula: Financial Leverage Ratio = Total Assets / Shareholders’ Equity

Total Assets refers to the total assets reported on the company’s balance sheet.

Shareholders’ Equity refers to the amount of equity or net assets held by shareholders, also reported on the balance sheet.

Debt ratio is total liabilities divided by total assets. It shows what percentage of assets are financed through debt rather than equity. A higher debt ratio indicates higher financial leverage and risk. 

For instance, a company’s debt ratio is 1,000,000 / 2,000,000 = 50% if its total assets are Rs. 2 million and its total liabilities are Rs. 1 million. This means 50% of its assets are financed through debt.

Debt-to-equity ratio is total liabilities divided by shareholders’ equity. It compares how much debt versus equity a company uses to finance operations. A higher ratio means more financial leverage and risk. For instance, a company’s debt-to-equity ratio is 1,000,000 / 500,000 = 2 if its total liabilities are Rs. 1 million and its shareholders’ equity is Rs. 500,000. This means it uses debt twice as much as equity to finance assets. 

Financial leverage ratios help investors assess risk. Companies with high leverage have volatile earnings and stock prices if interest rates rise. However, leverage also amplifies returns in good times. Investors must weigh the tradeoff between risk and potential returns based on a company’s financial leverage. 

17. Net leverage ratio

The net leverage ratio measures a company’s financial leverage after taking its cash reserves into account. It is calculated by taking total debt minus cash and cash equivalents, divided by earnings before interest, taxes, depreciation, and amortization (EBITDA). 

Formula: Net Leverage Ratio = (Total Liabilities – Cash & Cash Equivalents) / Total Equity

Total Liabilities includes all short-term and long-term debt obligations of a company. Cash & Cash Equivalents refers to cash, cash deposits, and liquid securities held by a company. Total Equity is made up of shareholders’ equity and retained earnings of a company.

For instance, a company’s net leverage ratio is (Rs. 50 million – Rs. 10 million) / Rs. 20 million = 2 if it has Rs. 50 million in total debt, Rs. 10 million in cash, and Rs. 20 million in EBITDA. This means its net debt is 2 times its EBITDA.

Unlike debt ratios based on total liabilities, the net leverage ratio accounts for a company’s cash reserves, which is used to service and pay down debt. A higher ratio indicates higher financial risk, while a lower ratio shows stronger capacity to cover interest expenses.

The net leverage ratio helps investors gauge a company’s ability to manage its debt burden. Highly leveraged firms sometimes struggle to service debt if earnings decline. However, responsible use of leverage also boosts returns during growth periods. 

Investors should evaluate a company’s net leverage trend over time as opposed to merely its absolute amount when assessing equities. A rising ratio could signal concern, while a declining ratio suggests improving financial health. Comparing leverage across industry peers also provides context on appropriate capital structure.

18. Combined leverage ratio

The combined leverage ratio is a measure used to assess the financial health and stability of companies, especially banks and other financial institutions. It looks at a company’s capital relative to its assets and exposures. 

Formula: Combined Leverage Ratio = (Tier 1 Capital + Tier 2 Capital) / Total Leverage Exposure

Tier 1 capital includes common equity and disclosed reserves, while tier 2 capital includes undisclosed reserves, revaluation reserves, general provisions, and subordinated debt. Total leverage exposure consists of on-balance sheet assets as well as off-balance sheet exposures.

A higher combined leverage ratio indicates that a company has more capital to absorb potential losses and withstand financial stress. A lower ratio suggests higher leverage and less ability to handle adverse conditions. Regulators typically set minimum combined leverage ratio requirements for financial institutions to reduce systemic risk.

The combined leverage ratio helps investors assess the financial stability and health of banks, insurance companies, brokerages, and other financial services firms. A company with a high ratio is less risky for investors. A low ratio could indicate excessive leverage and vulnerability in a market downturn.

Comparing combined leverage ratios over time for a company shows its changing capital adequacy and ability to withstand losses. Looking at ratios across companies in an industry sector enables comparing financial strength. The ratio complements regulatory capital ratios for a more complete view of leverage.

The various leverage ratios provide important insights into a company’s capital structure, debt capacity, and financial risk profile, which are key considerations for stock market analysis and investment decisions.

What is an example of leverage ratio calculation?

Let us evaluate the leverage of Infosys, one of India’s largest IT services companies, from an investment perspective.

The debt ratio measures the percentage of a company’s assets financed through debt. Infosys has total assets of ₹1,28,000 crore and total debt of ₹3,420 crore on its balance sheet. Its debt ratio is as stated below.

Debt Ratio = Total Debt / Total Assets 

            = ₹3,420 crore / ₹1,28,000 crore

            = 0.027 or 2.7%

This low debt ratio means only 2.7% of Infosys’ assets are funded by debt, while 97.3% are financed by equity and retained profits. A debt ratio below 0.5 is generally favourable for stocks, indicating lower financial risk. Infosys’ negligible dependence on debt provides more stability to its stock price compared to highly leveraged companies.

Conversely, the equity ratio determines the proportion of assets funded through shareholders’ equity. Infosys has ₹1,24,580 crore of shareholders’ equity. Its equity ratio is as stated below.  

Equity Ratio = Shareholders’ Equity / Total Assets

            = ₹1,24,580 crore / ₹1,28,000 crore 

            = 0.973 or 97.3%

The high 97.3% equity ratio complements the earlier debt ratio analysis. It implies Infosys relies overwhelmingly on equity rather than debt capital. This leads to less volatile earnings and stock prices during economic downturns.

Furthermore, the degree of financial leverage (DFL) measures earnings amplification from debt. Infosys has EBIT of ₹22,110 crore and EBT of ₹21,400 crore. Its DFL is as stated below.

DFL = EBIT / EBT

      = ₹22,110 crore / ₹21,400 crore

      = 1.03

The low DFL of 1.03 means a 1% rise in EBIT leads to only a 1.03% increase in EBT. This highlights Infosys’ low dependence on debt financing to boost returns. Conservative leverage reduces earnings growth but creates more stable stock value.

In addition, the net leverage ratio evaluates debt coverage relative to operating income. Infosys has ₹3,420 crore of debt and ₹1,510 crore of cash reserves. Hence, net debt is ₹1,910 crore. With EBITDA of ₹29,780 crore, its net leverage ratio is as stated below.

Net Leverage Ratio = Net Debt / EBITDA

                   = ₹1,910 crore / ₹29,780 crore 

                   = 0.064 or 0.064x

The net leverage of just 0.064x reflects Infosys’ miniscule net debt compared to strong operating cash flows. This gives it substantial financial headroom to invest in future growth initiatives. Conservative leverage benefits stock investors by minimizing balance sheet risk.

Finally, the capital gearing ratio indicates the split between debt and equity financing the company’s assets.

Capital Gearing Ratio = Debt / (Debt + Equity)

For Infosys:

Debt = ₹3,420 crore

Equity = ₹1,24,580 crore 

Gearing Ratio = ₹3,420 / (₹3,420 + ₹1,24,580)

              = 0.027 or 2.7%

This reinforces that Infosys predominantly uses equity capital rather than debt to fund its balance sheet and operations. The low financial risk provides stability to its stock through economic cycles.

How to compare leverage ratios of two companies?

To ascertain which of the pair of publicly listed enterprises carries greater financial risk from debt obligations, the proportion of total assets financed through borrowing rather than equity for each firm is examined, with the entity exhibiting the higher ratio considered more leveraged and thus more susceptible to distress from inability to meet interest and principal payments.

In the Indian stock market, comparing the leverage ratios of industry leaders like Reliance Industries and Tata Motors provide insight into their financial health. 

Reliance Industries Limited (RIL) is India’s largest private sector company, with businesses in energy, petrochemicals, textiles, retail and telecommunications. Tata Motors Limited is India’s largest automobile manufacturer, producing commercial vehicles, passenger cars, utility vehicles and defence vehicles. While in different sectors, both are major blue chip companies on the National Stock Exchange of India.

By looking at the latest available financial statements for FY 2020-21, we are able to calculate and compare key leverage ratios for Reliance Industries and Tata Motors. This analysis will shed light on their relative financial leverage and ability to service debt obligations.

For the fiscal year 2020-21, Reliance Industries had a debt-to-equity ratio of 0.55 and a debt-to-assets ratio of 0.35. This indicates that Reliance uses a mix of debt and equity financing, with equity making up a slightly larger share of its capital structure than debt. The leverage ratios show that Reliance’s assets and shareholders’ equity adequately support its current debt levels.

For fiscal year 2020-21, Tata Motors had high leverage ratios of 5.26 for debt-to-equity and 0.62 for debt-to-assets. This indicates Tata Motors relies heavily on debt financing, with debt exceeding equity by over five times and making up 62% of total assets. The high leverage exposes Tata Motors to increased financial risk.

Comparing the two companies, Tata Motors is significantly more leveraged than Reliance Industries based on its much higher debt-to-equity ratio of 5.26, versus just 0.55 for Reliance. This means Tata has over 5 times more debt compared to shareholder equity on its balance sheet. 

Similarly, Tata’s debt-to-assets ratio of 0.62 indicates that debt makes up a much larger 62% portion of its total assets, compared to just 35% for Reliance.

The high leverage ratios for Tata Motors increase its financial risk profile. The company is more reliant on debt financing and has less equity cushion on its balance sheet. This could be a concern for stock investors, especially in times of rising interest rates or slowing economic growth.

Meanwhile, Reliance Industries’ relatively lower leverage ratios demonstrate a more conservative financial profile, with less dependence on debt. It has a substantial equity base and finances just over one-third of its assets through debt. This provides more financial flexibility and lower risk.

Higher leveraged companies like Tata Motors tend to experience greater volatility in their share prices. During economic downturns, the combination of debt repayment obligations and slowing business growth severely impact finances and stock valuations.

On the flip side, lower leveraged firms like Reliance Industries are seen as more stable, defensive investments. The company is able to more comfortably service its debt obligations even if business conditions weaken. Its stock is likely to be less risky during periods of market turbulence.

Leverage ratios are just one metric for assessing a company’s financial health and investment profile. Other factors like profitability, growth prospects and valuation must be considered as well. But analyzing leverage does provide key insights into the balance sheet strength of Reliance Industries and Tata Motors.

What is a good leverage ratio?

Most analysts agree that a leverage ratio between 20-40% is reasonable for most public companies. General guidelines on good leverage ratios are: ratios under 30% are considered excellent; 30-40% is quite healthy; 40-60% is aggressive and riskier; over 60% is dangerously high. 

While those ranges serve as reasonable guidelines, the optimal leverage ratio varies significantly across different industries due to capital requirements. For example: utilities average 50-70%; oil & gas 30-50%; manufacturing 30-50%; technology 20-40%; consumer staples 20-30%. High-growth industries support little to no leverage, while highly cyclical industries sustain low leverage. In addition, larger and more mature companies tend to operate with higher leverage compared to smaller companies.

The stage of the economic cycle also influences suitable leverage ratios. In strong economies, higher leverage is acceptable since cash flows and margins are healthy. But in recessions, lower leverage provides a cushion and stability in earnings. Investors should constantly look at a company’s leverage ratios over time and compare them to those of rivals when investigating possible investments. Other factors to assess include debt-to-equity trends, interest coverage, cash flow to debt, credit rating, debt terms, and access to capital. 

What does high leverage ratio mean?

A high leverage ratio for a company in the stock market indicates it is heavily dependent on debt financing and carries higher financial risks as a result. This is either positive or negative for stock investors, depending on the specific circumstances.

The most basic implication of a high leverage ratio is that a company has a large amount of debt relative to its size. The higher the ratio, the greater the company’s debt burden. For example, a leverage ratio of 0.8 means debt accounts for 80% of total assets. Meanwhile, a ratio of 2.5 means debt is 2.5 times greater than equity. The higher the ratio, the more debt financing a company utilizes to fund growth compared to equity financing.

Judicious use of leverage provides benefits. Debt provides tax advantages, since interest payments are tax deductible. Wisely invested borrowed money boosts returns on equity if the return on assets funded by debt exceeds the interest rate. For companies with high fixed costs and low variable costs, modest leverage helps magnify returns in good times. Sustainable leverage demonstrates lender confidence in the company’s financial health. Hence, some debt on the balance sheet benefits shareholders.

However, excessive leverage poses considerable risks. Companies with already high fixed costs take a larger earnings hit in downturns if fixed debt service costs are also high. The high interest costs on large debt loads depress net income, reducing valuations. Meanwhile, lenders impose strict loan covenants on highly leveraged borrowers. Violations of covenants due to poor results lead to technical defaults, triggering demands for immediate repayment.

A highly leveraged company also has less financing flexibility when business conditions deteriorate. Lenders will be wary of providing additional credit. Issuing more stock to raise equity is difficult when valuations are low. The company is forced to take drastic actions like asset sales, capital expenditure cuts, or massive layoffs to fulfil debt payments. All of this harms shareholder value.

The optimal leverage level varies between industries, based on business models and volatility. For example, utility stocks safely sustain very high leverage ratios, thanks to their recession-proof demand and stable earnings and cash flows. On the other hand, cyclical sectors like auto manufacturers cannot prudently carry nearly as much debt.

Within sectors, comparing leverage ratios helps identify outliers with particularly aggressive or conservative capital structures. A retailer’s debt load is disproportionately large if, for instance, its peers have a leverage ratio of 2.0 and it is 5.0. Looking at changes in an individual company’s leverage over time also provides insight. A sharp, sudden rise indicates overly risky borrowing to fund expansions or acquisitions.

While the leverage ratio examines the debt load, investors must also consider the company’s ability to manage it. The interest coverage ratio compares earnings to interest costs. A lower ratio indicates tighter margins for error to meet obligations. The debt service coverage ratio compares cash flow to total debt service, showing the cushion for making required principal and interest payments. Even with high leverage, strong coverage ratios sometimes allay concerns.

Excessive leverage has tangible effects on share prices. The higher risk of distress or default depresses equity valuations and increases volatility. Leverage amplifies reductions in net income and equity value, which accelerates them when profits drop. These impacts help explain why stocks with higher leverage ratios tend to underperform their less leveraged peers, especially in downturns.

Where to find leverage ratios of a company?

Strike, a stock market analysis platform, helps investors find and analyze key leverage ratios of public companies. Investors will be find common leverage ratios like debt-to-equity ratio and times interest earned reported on Strike to assess financial risk and inform their investment decisions.

What does low leverage ratio mean?

A low leverage ratio for a company traded on the stock market indicates it has less debt relative to equity and assets, reducing its financial risk but also potentially limiting returns for shareholders.

A low leverage ratio is generally seen as a positive sign for a stock, as it indicates less financial risk. Companies with high leverage ratios are considered to be highly leveraged. This means they have taken on substantial debt loads and interest payment obligations relative to their asset bases. Highly leveraged companies have considerable risk if cash flows decline, as they sometimes struggle to meet debt payments. Their high debt levels also increase the risk of insolvency or bankruptcy.

In contrast, companies with low leverage ratios have less debt on their balance sheets proportionate to total assets/equity. Their lower debt burdens and interest costs make them less financially risky in the face of declining revenues or profits. While their equity investors make lower returns in strong markets, lower leverage reduces risk of equity being wiped out in downturns.

For instance, Company A’s leverage ratio is 20% (Rs. 20 million/Rs. 100 million assets) if its total assets are Rs. 100 million and its total debt is Rs. 20 million. Company B has Rs. 100 million in assets but Rs. 80 million in debt, resulting in leverage of 80%. Company A has far less financial risk due to its lower debt leverage.

While low leverage minimizes risk, it also limits gains for shareholders. Taking on debt magnifies returns in good times. Company B in the example above could potentially generate much higher returns in strong markets, as debt provides leverage. But Company B’s high debt load makes it vulnerable in downturns.

Company A’s lower leverage provides more stable, less volatile returns. But investors in Company A likely forgo the higher peaks Company B could achieve in up markets. This trade-off between risk management and return potential is why analyzing leverage ratios is a key part of researching stocks. The capital structure of a corporation must be compared to an investor’s risk tolerance.

Conservative investors often favour stocks with lower leverage. But higher risk investors sometimes specifically target stocks with higher leverage, accepting the risks for the potential returns. Most analysts consider leverage ratios between 10-40% to be prudent for established companies. Startups and young companies sustain somewhat higher leverage, as they have greater growth prospects. 

It is also important to compare leverage ratios amongst companies within the same industries. The optimal leverage level differs across industries based on factors like asset types, growth rates, and sensitivity to economic cycles.

For example, capital intensive utilities and telecoms prudently operate at higher leverage levels than tech companies, since their assets and cash flows are more stable. Comparing a tech company’s leverage ratio to a utility’s could be an apples to oranges comparison. Assess leverage in the context of what is common for the industry.

What are the limitations of leverage ratios?

Leverage ratios have limitations such as lack of universal optimal levels, reliance on snapshots of book values, ignorance of qualitative factors, accounting inconsistencies, lack of risk adjustments, exclusion of market values, limited insights into leverage management, asset risk disparities, omission of off-balance sheet leverage, and inability to fully assess liquidity risk.

One limitation of leverage ratios is that there is no universal “optimal” leverage ratio that applies to all companies. The appropriate amount of leverage depends on factors like the industry, business model, growth stage, economic conditions, credit quality, and risk tolerance. For example, early-stage biotech firms tend to carry more debt relative to equity because they have minimal revenue and profits. Mature utility companies often operate with high leverage as well since they generate stable cash flows to service debt. But leverage ratios that seem reasonable in one industry are dangerously high in another. Investors must assess leverage in the proper context.

Another shortcoming is that leverage ratios provide a snapshot in time but don’t reflect trends. A company temporarily takes on more debt to finance a merger or expansion, causing its leverage ratios to spike. But ratios will improve once the deal is completed and debt is paid down. Looking at leverage trends over time rather than at a single point provides more insight. Also, comparing leverage ratios to a company’s historical norms or industry peers gives a better sense of appropriate leverage levels. Isolated ratios have less meaning.

Leverage ratios also focus narrowly on financial statement data while ignoring other factors that influence risk. For instance, ratios don’t reflect business diversity, revenue stability, pricing power, operating efficiency, industry competition, access to capital, or the quality of management—all factors that affect a company’s ability to handle debt. And since book values of assets are used to calculate ratios, leverage sometimes appears conservative though assets might actually be overvalued. Market values of equity provide a more realistic representation of leverage in some cases.

Further, leverage ratios depend heavily on accounting definitions of debt, equity, assets, and earnings. These definitions vary significantly between companies. For example, operating leases are a major form of financing in sectors like retail and airlines, but leases are considered off-balance sheet financing. So two firms have very different real debt burdens but similar leverage ratios based on balance sheet debt. Ratios should be supplemented with other metrics to better understand true leverage. 

Leverage ratios also lack sector-specific or geographic risk adjustments. The optimal leverage for an oil company is very different from that of a defence contractor, for example. And country risk varies—debt levels considered safe in the U.S. could be risky in emerging markets. But simple leverage ratios treat all sectors and geographies equally. To fully assess leverage, ratios should be viewed within relevant risk contexts.

Moreover, since book values are used to calculate leverage, ratios fail to capture the market value of equity, which fluctuates continuously. Suppose a company has equity of Rs. 100 million on its balance sheet. The company’s leverage ratios would be halved even if its debt hasn’t changed if its share price doubles later on, making the market value of stock Rs. 200 million. Leverage ratios based on static book values miss the market’s real-time judgement of risk.

Leverage ratios also provide little insight into how leverage is managed day-to-day. For example, ratios don’t reveal whether debt is issued prudently only for productive purposes or recklessly for share buybacks. And they don’t indicate what types of debt are used—short-term debt generally poses more risk than longer-term debt. Two firms with identical leverage ratios sometimes actually have very different risk profiles based on how debt is accessed and deployed.

In addition, leverage metrics ignore the assets funded by debt—not all assets have equal risks. Debt supporting steady cash-generating assets like real estate is less risky than debt funding volatile assets like commodities. A given leverage ratio could be conservative or aggressive depending on the assets it funds. Understanding where debt is invested provides critical context for interpreting leverage.

Furthermore, ratios assess balance sheet leverage but ignore off-balance sheet leverage from derivatives, joint ventures, pension underfunding, and contingent liabilities. For example, derivatives amplify exposure to stocks, bonds, currencies, or commodities without requiring upfront funding or affecting leverage ratios. Ratios should be viewed together with footnotes about off-balance sheet risks.

Finally, leverage ratios provide an incomplete picture of liquidity risk—the risk that debts will not be refinanced or repaid. Liquidity depends on cash flows, earnings coverage of interest, debt maturity profiles, covenants, and funding capacity, not just gross debt levels. A company with high leverage but abundant liquidity is less risky than one with lower leverage but inadequate cash flow to service debts. Liquidity analysis is essential alongside leverage ratios.

How leverage is created?

Leverage in stock trading arises when investors use borrowed capital to increase the potential returns on their investment, thereby magnifying both gains and losses compared to investing only the capital they have.

One of the most common ways to create leverage is by borrowing money to invest. For example, an investor sometimes takes out a loan from their brokerage to purchase more stock shares than they could otherwise afford with their own capital. This allows the investor to control a greater number of shares and benefit more from potential gains, but it also exposes them to greater losses if the share price declines. The amount of leverage depends on the ratio of borrowed funds to the investor’s own capital. 

An investor has generated 2:1 leverage if they have Rs. 10,000 of their own funds to invest and borrow an additional Rs. 10,000 from their brokerage. This gives them a total of Rs. 20,000 to invest. For every 1% increase in the share price, their portfolio goes up 2% because they control twice as many shares. But they also face twice the losses if the share price drops. Leverage amplifies movements in both directions.

Margin trading refers to borrowing funds from a brokerage firm using the current securities in one’s account as collateral. The investor does not need to take out an actual loan – the brokerage lends them additional buying power in return for a pledge of securities. 

The brokerage sometimes lends an investor up to 50% of the value of their Rs. 10,000 worth of stocks, for instance, in order to increase their purchasing power. This allows the investor to buy Rs. 15,000 worth of additional shares while still only committing their original Rs. 10,000. This creates 1.5:1 leverage and further amplifies both gains and losses on the position.

Options are derivatives that give investors the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date. Call options confer the right to buy, while put options confer the right to sell. Options leverage arises from the fact that the price paid to purchase an option is much less than the price of buying the underlying asset outright.

For example, instead of purchasing 100 shares of a Rs. 50 stock for a cost of Rs. 5,000, an investor could buy one Rs. 50 call option contract for only Rs. 500. This allows them to control 100 shares while only tying up Rs. 500, creating 10:1 leverage. The Rs. 500 investment is forfeited in full should the option expire out of the money.

Short selling involves borrowing shares of a stock from a brokerage firm and selling them on the open market, with the intention of repurchasing the shares later at a lower price to return to the lender. This allows traders to profit from declining stock prices. The brokerage charges interest on the borrowed shares.

Again, this creates leverage – a trader gains greater short exposure to a stock without having to borrow and sell the full market value. For example, borrowing and shorting Rs. 5,000 worth of shares creates 5:1 leverage against the trader’s account balance. The trader suffers rapid losses in case the share price increases and they are compelled to repurchase at a higher level, while gains are magnified if the stock price lowers.

Futures contracts are agreements to buy or sell a predetermined quantity of a commodity, currency, or financial instrument at a fixed date in the future. Futures are traded on margin, which allows traders to put down a fraction of the full value of the contract as collateral when establishing a position.

For example, a standard futures contract for the S&P 500 index represents Rs. 250,000 worth of stock market exposure. However, an investor only needs to put down Rs. 10,000 to Rs. 15,000 as initial margin to control the contract. This creates leverage of 15:1 to 25:1. The futures trader participates in all the upside and downside price movements despite having invested a fraction of the full face value.

What are the risks of high operating leverage and high financial leverage?

High operating leverage and high financial leverage amplify risks for stock investors, as they create greater volatility in earnings and increase the likelihood of financial distress during industry downturns.

Operating leverage refers to the amount of fixed costs in a company’s cost structure relative to variable costs. Companies with high operating leverage have a large portion of fixed costs such as equipment, factories, and overhead. This leads to greater fluctuations in profitability, as once fixed costs are covered, a large portion of revenues turn into profits. However, the same dynamic cuts the other way – if revenues decline, profits fall sharply as the fixed costs remain. 

In the stock market, high operating leverage poses risks for investors. All things considered, revenues are expected to decline if the economy experiences a downturn. Companies with high operating leverage will see their profits drop disproportionately due to their large fixed costs. This leads to steep declines in earnings per share and sends the stock price plummeting. Investors are sometimes caught off guard by the extreme earnings volatility. On the other hand, companies with low operating leverage weather downturns as the majority of their costs vary with revenue. Their earnings and stock prices are less sensitive to economic fluctuations.

Financial leverage refers to the level of debt financing a company uses relative to equity financing. Debt comes with required interest payments that raise a company’s fixed costs. Companies with high financial leverage have a heavy debt load and high interest expense. This magnifies risk for stock investors.

During recessions, high debt levels put strain on earnings as interest payments remain fixed while income drops. A highly leveraged company might breach debt covenants and be forced to take on emergency financing with restrictive terms. The additional interest burden worsens profitability struggles. With debt consuming cash flows, dividend cuts are sometimes required. All of these factors hurt investor confidence and drag down the stock price. Should things go bad enough, the firm will have to declare bankruptcy, which would mean that stockholders would lose everything. 

Conversely, companies with low financial leverage are at less risk in downturns. Their lighter debt loads are more manageable even with declining profits. Interest expense remains a smaller portion of costs so earnings hold up better. The risk of violating debt terms or covenants is reduced. With less debt overhang, the company has financial flexibility to maintain dividends and invest for the future. Shareholders face lower risk of extreme losses, supporting a higher stock valuation.

Investors are exposed to greater risk when a firm exhibits both high operating and high financial leverage. The large fixed cost base combined with heavy debt obligations creates a precarious situation. Even a mild drop in revenue wipes out earnings due to the magnifying effects of operating and financial leverage. This leads to much greater earnings volatility compared to a company with low leverage. 

In a recession, the dual leverage presses heavily on profits. Loan covenants are sometimes triggered, forcing the company to take on emergency financing with onerous terms. Dividends will almost certainly need to be cut to preserve cash. The stock price typically crashes under these pressures as investors price in higher risks of bankruptcy and dilution. While the high leverage allows for amplified returns in good times, shareholders bear the consequences when business turns down.

What is the relation between leverage ratios & coverage ratios?

Leverage ratios measure a company’s debt burden while coverage ratios assess its ability to service that debt, so higher leverage typically leads to lower coverage, increasing risks for stock investors.

Leverage ratios such as debt-to-equity and debt-to-capital measure the degree to which a company finances itself with debt versus equity funding. They demonstrate how leveraged the company’s balance sheet is – the higher the leverage ratio, the more debt relative to shareholder equity. 

Coverage ratios like interest coverage and debt service coverage compare a company’s earnings or cash flow to required interest and debt payments. They gauge the company’s ability to comfortably make those fixed financing payments. 

The primary relationship between leverage ratios and coverage ratios is that higher leverage leads to lower coverage. As a company takes on more debt relative to equity, it raises its fixed financing costs in the form of higher interest payments. Those larger interest payments then lower the company’s coverage ratios.

In the stock market, analyzing how leverage impacts coverage provides insights on default risk and earnings stability. A company with low leverage but high coverage has minimal risk of missing debt payments and stable earnings to support dividends. Conversely, a highly leveraged company with low or declining coverage ratio faces higher risk of default. Its thin coverage margin magnifies even small revenue declines into large earnings hits. 

Investors need to evaluate the dangers of volatility and financial hardship against the larger profits made possible by excessive leverage when determining the value of stocks. For companies operating in stable sectors, higher leverage is acceptably risky. However, cyclical industries and emerging companies often cannot sustain high leverage through their volatile cycles.

Changes in leverage and coverage over time also give important signals about a company’s financial trajectory. Increasing leverage accompanied by declining coverage indicates management is over-burdening the company with debt. This pressures both liquidity and profitability. To turn the trend, the company needs to raise equity, cut dividends, or sell assets to reduce debt. 

In a recession, the financial ratio of debt to equity, a measure of leverage, becomes critically important. As earnings decline, the burden of debt relative to equity increases, doubling the pressure on the company’s finances. This dual impact of leverage, reflected in the financial ratio, can trigger loan covenants, forcing the company to seek emergency financing often at unfavorable terms. Additionally, to preserve cash, dividends are likely to be cut, exacerbating the situation. The stock price typically suffers under these dual pressures, as investors recognize the heightened risks of bankruptcy and potential dilution. While this financial ratio of debt to equity can enable amplified returns in prosperous times, it also means that shareholders face heightened risks when the business cycle turns downward.

What is the difference between leverage ratio & liquidity ratio?

The leverage ratio measures a company’s financial leverage by comparing its debt to assets or equity, while liquidity ratios like the current ratio measure a company’s ability to pay off short-term liabilities with its current assets, indicating its financial health and stock performance.

The leverage ratio specifically measures a company’s use of debt financing relative to equity financing to fund operations and growth. Also called the debt-to-equity ratio, the leverage ratio compares a firm’s total debt to shareholders’ equity by dividing total liabilities by total shareholders’ equity. A higher leverage ratio indicates greater financial leverage and debt burden on the company.

The leverage ratio helps investors assess a company’s long-term solvency, risk capacity, and ability to weather downturns. A high degree of leverage implies higher risk for a company and its stock. It means the company relies heavily on debt, so its ability to pay fixed costs and interest expenses is vulnerable to earnings fluctuations. Even a minor drop in profits or cash flow could make it difficult for a highly leveraged company to service its debt. This financial risk exposes shareholders to potential dilution or loss of equity.

Conversely, a low leverage ratio indicates the company is financed mostly through equity rather than debt. It has a less risky capital structure with lower fixed costs and interest burden. The company will more flexibly be able to manage volatility and downturns. For stock investors, low leverage offers a margin of safety and downside protection. Conservative leverage helps maintain capital appreciation and dividends during market corrections when stock prices fall.

Unlike the leverage ratio, liquidity ratios specifically measure a company’s ability to pay short-term financial obligations and expenses. The two most common liquidity ratios used are the current ratio and quick ratio. 

The current ratio compares current assets like cash, accounts receivable, and inventory to current liabilities like accounts payable, wages, and short-term debt. A higher current ratio indicates a company will be able to more easily pay off its near term liabilities. A ratio under 1 means its current liabilities exceed current assets and the firm sometimes will struggle to maintain short term liquidity.

The quick ratio is more conservative. Also called the acid test ratio, it measures a firm’s capacity to pay current liabilities with its most liquid assets i.e. cash and cash equivalents, short-term investments or receivables. The quick ratio excludes less liquid current assets like inventory.

For stock investors, liquidity ratios provide critical insight into a company’s financial position and flexibility. Healthy liquidity suggests the company has an adequate cash buffer and assets that are quickly converted to cash as needed to meet operating expenses. Even profitable companies experience distress if they lack sufficient liquidity.

Strong liquidity means the firm is able to comfortably handle short-term cash outflows and near term obligations as they come due. Stockholders benefit through steady dividend payments and avoidance of emergency measures like burdensome borrowing, stock dilution, or being forced to sell assets at unfavourable prices. Robust liquidity indicates an enterprise with staying power.

While leverage and liquidity ratios provide distinct insights, they are interconnected measures of financial health. Leverage evaluates long-term solvency by measuring future debt obligations and risks. Liquidity focuses on near-term flexibility to meet current cash needs. A company with high leverage but low liquidity signals heightened bankruptcy risk, as high debts are paired with insufficient cash reserves. 

In contrast, low leverage and high liquidity indicate fundamental financial stability, as manageable debts are supported by healthy cash generation. 

How leverage ratios help in fundamental analysis?

Leverage ratios help in fundamental analysis by providing insights into a company’s financial health and ability to meet its debt obligations, summarising how much debt a company uses to finance assets.

Fundamental analysis involves assessing a company’s financial statements, management, competitive advantages, and industry dynamics in order to determine the fair value of its stock. A key part of this process is analyzing leverage ratios, which measure how much debt a company uses to finance its assets and operations. High leverage produces higher returns in good times but also increases the risk of insolvency in downturns. As such, leverage ratios provide crucial information on the balance sheet strength and bankruptcy risk of a company.

The three most common leverage ratios used in fundamental analysis are the debt-to-equity ratio, interest coverage ratio, and debt-to-EBITDA ratio. The debt-to-equity ratio compares a company’s total debt to its shareholder equity, showing the extent to which operations are financed by creditors versus owners. A high debt-to-equity ratio indicates aggressive financing with debt and thus higher risk. The interest coverage ratio measures a company’s ability to pay interest expenses based on its operating income. A lower coverage ratio means there is greater risk of missing interest payments. Finally, the debt-to-EBITDA ratio looks at how many years it would take for a company to pay back its debt given its cash flow generation. Higher ratios indicate higher credit and bankruptcy risk.

Leverage ratios help analysts identify red flags and also compare relative risks between companies. For example, within an industry Leverage ratios provide crucial information on the balance sheet strength and bankruptcy risk of a company.

Leverage ratios help analysts identify red flags and also compare relative risks between companies. For example, within an industry like retail, one company has a debt-to-equity ratio of 2.5x while another has a ratio of 0.5x. This signals that the higher levered firm carries significantly more bankruptcy risk. Similarly, analysts use leverage ratios to assess risk over time for a single company. A rising debt-to-EBITDA ratio from one year to the next sometimes indicates a company has too much debt given its operating income. These insights help determine the health and stability of a company’s finances.

Excessive leverage imposes risks that ultimately harm shareholder value. Companies with high debt burdens end up needing to raise capital through dilutive secondary offerings or cut dividends. Highly leveraged firms also have less flexibility to invest for growth or weather industry shakeups. However, leverage ratios alone do not tell the whole story. Other factors like cash flow adequacy, growth prospects, and asset quality also matter. As such, leverage ratios are most useful as part of an overall fundamental analysis.

Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.