What is a leverage ratio?

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Leverage ratio is a term that includes various ratios that assess a company’s financial leverage.  These ratios show the relationship between a company’s liabilities and its assets and equity, and help investors quickly see how indebted a company is, relative to its size.

Here are some common leverage ratios, their formulas and when to use them.

Debt-to-capital ratio and how to calculate it

The debt-to-capital ratio measures a company’s leverage by assessing how much debt the company has versus how much total capital it has. It is determined by dividing a company’s total debt (short-term and long-term) by its total capital, which is debt plus shareholders’ equity.

Debt-to-capital = Total debt / (Total debt + Shareholders’ equity)

For example, if total debt is $4 million and shareholders’ equity is $12 million, then the debt-to-capital ratio is $4 million/$16 million = 0.25, or 25 percent. To find these numbers, refer to a company’s balance sheet.

What it means

The higher the debt-to-capital ratio, the more of a company’s capital comes from debt than from shareholder equity, and the lower the debt-to-capital ratio, the more of a company’s capital comes from shareholder equity.

A higher ratio typically implies a greater level of risk for the company, since debt payments must be made regularly or the company risks going into default and bankruptcy. And lower shareholders’ equity suggests that the company does not have sufficient financial resources if tough times emerge.

The ideal debt-to-capital ratio varies by industry and company size, but in general it should not exceed 0.5. For example, a debt-to-capital ratio of 0.5 means that one-half of the company’s capital is funded through debt and one-half through shareholders’ equity.

Businesses with lumpy cash flows — fluctuating income and expenses — need to have lower levels of debt to avoid trouble making payments on the debt, while those with more reliable cash flows can run with higher debt levels and still operate fine.

Debt-to-equity ratio and how to calculate it

The debt-to-equity ratio measures a company’s debt against its shareholders’ equity. It is determined by dividing a company’s total debt (short-term and long-term) by its total equity.

Debt-to-equity ratio = (Total debt) / Shareholders’ equity

For example, a company with $4 million in debt and $12 million in shareholders’ equity would have a debt-to-equity ratio of 0.333, or 33.3 percent.

What it means

A higher ratio typically implies a greater level of risk for the company, since debt payments must be made regularly or the company risks going into default and bankruptcy. A lower ratio suggests that the company has sufficient equity capital to weather a business downturn. For investors, a high ratio is often a warning that the company is riskier because it relies on debt financing.

The optimal ratio varies by industry and the nature of the business. Companies with strong recurring cash flows can operate safely with higher levels of debt, while less stable businesses should rely more on shareholders’ capital.

The debt-to-equity ratio focuses solely on the equity portion, while debt-to-capital ratio considers both debt and equity in the calculation. Debt-to-equity ratio highlights the relationship between debt and equity, while debt-to-capital ratio provides a broader view of a company’s overall capital structure.

Interest coverage ratio and how to calculate it

The interest coverage ratio shows a company’s ability to pay interest on its outstanding debt. It is figured by dividing the company’s pre-tax, pre-interest earnings by its interest expense.

Interest coverage ratio = EBIT (earnings before interest and taxes) / Interest expense

For example, a company with earnings before interest and taxes of $20 million and interest expense of $5 million would have interest coverage of 4 times.

What it means

A higher interest coverage ratio typically indicates better financial stability and the ability to repay debts, since the company can see earnings fall some and yet still be able to pay interest on its debt.

The optimal ratio can vary substantially between companies and industries. Companies in cyclical industries, for example, should have ample interest coverage in order to withstand downturns. Companies with highly regular cash flows – many real estate investment trusts (REITs) or consumer subscription businesses, for example – can run with relatively low interest coverage and still thrive.

Fixed-charge coverage ratio and how to calculate it

The fixed-charge coverage ratio measures how effectively a company’s earnings can cover its fixed monthly charges, such as debt payments, interest costs and lease expenses. It’s calculated by adding interest expense, lease expense and other fixed charges to a company’s EBIT from the income statement and then dividing by those fixed charges.

Fixed-charge coverage ratio = (EBIT + fixed charges before taxes) / (Fixed charges before taxes + interest expense)

For example, a company with earnings before interest and taxes of $20 million, pre-tax fixed charges of $5 million and interest expense of $5 million would have fixed-charge coverage of $20 million + $5 million divided by the sum of $5 million and $5 million, or 2.5 times.

What it means

A higher fixed-charge coverage ratio shows better financial stability and the ability to repay the company’s debts and other ongoing “must pay” expenses. With a high ratio, the company can see profits fall some and yet still be able to “keep the lights on.”

The ideal ratio can vary substantially between companies and industries. Companies with irregular profitability should have ample fixed-charge coverage in order to withstand an economic downturn. Fixed charges can hit cyclical companies hard, since they have to cover payments regardless of how much money is coming in the door.

Net debt-to-EBITDA ratio and how to calculate it

The net debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratio measures how much debt a company has for the cash flow it generates.The ratio shows how long it would take for a business to repay its debt if net debt and EBITDA remain stable.

Net debt-to-EBITDA ratio = (Total debt – cash and cash equivalents) / EBITDA

For example, a company with EBITDA of $25 million, total debt of $85 million and cash of $10 million would have a net debt-to-EBITDA ratio of $85 million – $10 million divided by $25 million, or 3 times.

What it means

A higher debt-to-EBITDA ratio indicates decreased financial stability, all else equal. High levels of debt relative to the company’s cash flow to support that debt could indicate financial stress. Additionally, if total debt exceeds total cash, then a company can be pushed into bankruptcy if its lenders call in their loans, which can happen if there’s an accounting scandal.

However, because of the tax benefits of using debt — interest expense is tax-deductible — it can make sense for companies to use some level of debt, even if they don’t exactly need it. Many companies can safely run with a ratio of 1 or even 2 times, but companies that have ratios of 4 or 5 times or more need predictable cash flows in order to be sure that they don’t run into financial hardship.

Operating leverage ratio and how to calculate it

The operating leverage ratio shows the impact of a given sales increase on a business’s income before interest and taxes. The ratio measures the relationship between a business’s contribution margin and its net operating income.

Operating leverage ratio = Percentage  change in EBIT /  Percentage change in sales

For example, a company that grew earnings before interest and taxes by 20 percent on a 10 percent increase in sales would have operating leverage of 2 times.

What it means

A higher operating leverage ratio shows that a business can grow profits faster for any given sales increase. So generally speaking, the higher the operating leverage ratio, the better.

What is considered a good operating leverage ratio depends heavily on the industry. Industries that deliver physical products may have relatively low operating leverage, while those that deliver “knowledge products” such as software or advice may have very high operating leverage.

Bottom line

Leverage ratios are important tools for measuring a company’s financial health and risk. Knowing when and how to wield these calculations can lead to valuable investor insights, but they’re just a starting point for understanding what’s going on inside a company and what’s driving the numbers.