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Leverage and Financial Leverage Metrics (Gearing Ratios)
How to Calculate, Interpret, and Use Leverage Metrics, Step by Step

Leverage is the use of borrowed funds to increase earnings
 

Leverage metrics compare funds creditors supply to the firm to funds that owners supply. Owners and creditors alike have a keen interest in these metrics because they share business risks and rewards in proportion to their share of the funding.

Leverage metrics show how a firm's owners and creditors share business risks and rewards.

What are Financial Leverage Metrics?

Financial leverage is a tactic by which individuals and companies increase their earning power through borrowing.

Some business people call leverage metrics gearing ratios. This name clearly points to the analogy with mechanical leverage:

  • Humans and machines use mechanical leverage to amplify their lifting power by configuring levers, gears, or pulleys to trade off movement and force.
  • Investors and owners use financial leverage to amplify their earning power by borrowing funds that increase their investment stake.

In other words, businesspeople use leverage when they expect to earn more from the funds they borrow, than the cost of borrowing.

Owners, financial officers, and investors know that leverage comes with potential rewards but also potential risks. As a result, they take a keen interest in measuring leverage strength or equivalently, level of leverage, or leverage exposure. For this, they rely on a family of leverage metrics—the subject of this article.

Define Leverage, Measure Leverage

Financial analysts define leverage in practical, easy-to-measure terms. The definition refers specifically to the sources of funds that firms use to to acquire assets, which are either owners or creditors. To measure leverage, the analyst compares the funds that creditors supply to a firm, to the funds that owners supply.

Each of the 5 leverage metrics below makes this comparison in its own way. All of these metrics will show when creditors provide substantially more funding than owners, and in such cases, the firm is operating with high leverage.

To the analyst, leverage metrics measure the increase in earning power a firm can expect from borrowing, when the business is doing well. And, the same leverage metrics show how the firm loses earning power when business is doing poorly. Both creditors and owners share enterprise risks and rewards, but in proportion to their share of the funding. Thus, when a high leverage business fails, creditors have more to lose than owners.

Why Do Firms Use Leverage?

Why do profitable firms borrow funds when they can continue operating without doing so? The answer has to do with the ways that firm invest in their own businesses. Borrowing results in leverage, which can increase the profitability of the firm's investments.

  • In a strong economy or when the business is otherwise doing well, owners may earn more on funds they borrow than they pay for the cost of borrowing. This in fact is the reason owners use leverage. When business is healthy, leverage increases earning power.
  • The reverse can be true in a poor economy or if the firm performs poorly for other reasons. As a result, earnings may not even cover interest due on loans. In this case, borrowing costs are therefore especially burdensome for owners. This is because leverage decreases earning power when business is poor.

Capital Structure and Financial Structure

Note that the leverage metric Long-Term Debt-to-EquitiesRatio equates to the firm's capital structure. Similarly, the Total Debt to Equities Ratio metric is essentially equivalent to the firm's financial structure. The two structures and these two debt-to-equities ratios provide different ways to compare equity funding to debt funding.

Incidentally, it is correct to write the names of these ratios with or without hyphens. This article uses hypens but sources that omit hyphens are equally correct.

Measuring and Interpreting Leverage in Context

This article further explains and illustrates the debt-to-equities ratios, along with three other ratios (leverage metrics) in frequent use that also compare the firm's funding sources. Explanations and calculations show how to use and evaluate each metric in context with the others.

Five steps in the following Sections explain how to calculate and interpret the following leverage metrics:

  • Total debt-to-assets-ratio (Debt ratio).
  • Total debt-to-equities ratio.
  • Long-term debt-to-equities-ratio.
  • Equity-to-assets ratio.
  • Times-interest-earned.
 

Contents

Related Topics

 

Leverage Ratios and Other Metrics in Finance and Business Analysis
Business Ratios as Leverage Metrics

Leverage metrics (gearing ratios) are a financial metrics family—one of six metrics families that business people call either Fnancial Statement Metrics or Business Ratios. Generally, these metrics use figures from financial reports to assess the firm's financial performance and financial position. Metrics Input data come primarily from the financial accounting reports in Exhibit 1.

Four financial statements
 

Exhibit 1. The firm's four financial statements provide most of the input data for levereage metrics and other business ratios.

Some businesspeople refer to all financial statement metrics as "business ratios." That is because they calclulate most of these metrics by dividing one financial statement figure into another. Language purists note, however, that a few of these metrics are not ratios. The Working capital metric, for instance, is the difference between two Balance sheet figures, not a ratio.

Who Uses Financial Statement Metrics? For What purpose?

Several groups take a keen interest in financial statement metrics.

  • Investors and investment analysts carefully weigh the firm's financial statement metrics when they consider trading bonds or shares of stock.
  • The firm's officers and managers use financial statement metrics to identify strengths, weaknesses, and target levels for business objectives.
  • Shareholders and boards of directors depend on these metrics for evaluating management performance.

Meet Six Families of Financial Statement Metrics

Each financial statement metrics family addresses one kind of question about the firm and its finances. The six metrics families and the kinds of questions each addresses are the following.

  • Activity and efficiency metrics (the subject of this article).
    Activity metrics ask: Does the firm use resources efficiently?
  • Liquidity metrics.
    Liquidity metrics ask: Can the firm meet its near-term spending needs?
  • Valuation metrics.
    Valuation metrics ask
    : What are the firm's prospects for future earnings?

Sections below illustrate popular Leverage metrics. Links immediately above for other metrics families lead to similar coverage on other pages for Profitability, Growth, Activity, Liquidity, and Valuation metrics.

How to Calculate, Interpret Leverage Metrics (Gearing Ratios) in 5 Steps
Five Metrics for Measuring Financial Leverage

The sections below present five leverage metrics that are central in business analysis today. The text explains the essential meaning of each metric, shows example calculations, and discusses rules of thumb for interpreting metrics results.

Notice that most of the input data for the examples come from the Exhibit 2 Income statement and the Exhibit 3 Balance sheet, lower on this page.

Measuring Leverage Step 1
Calculate and Interpret the Total Debt-to-Assets Ratio (Debt Ratio)

Leverage is the use of borrowed funds to increase earnings
 

When a firm goes out of business and into liquidation, it sells off its assets to meet obligations to creditors and owners. The firm's creditors have first claim on proceeds from asset liquidation. Potential lenders or bondholders for any firm want assurance that in the worst case scenario, the firm can at least pay off its debts. The Total debt-to-asset ratio provides this information. Potential lenders prefer debt/asset ratios well under 1.0.

Can the company pay off its creditors in case the business fails?

The total debt to assets ratio addresses this question. This metric is the simple ratio of two Balance sheet figures in its name, total debt (total liabilities) and total assets.

  • The Balance sheet equation ensures that the total assets equates to the firm's total funding. In other words, Total Assets = Total Liabilities + Total Equities
  • Creditors provide the "Total Liabilities" portion of Total funding.

In other words, the total debt-to-asset ratio indicates directly whether or not the asset base covers the firm's total debt. A Total-Debt/ Asset ratio less than 1.0 says to creditors that asset value is sufficient to pay off the debt.

Calculating the Total Debt-to-Assets Ratio.

The ratio name describes the calculation. Note also that this example uses figures from the Exhibit 3 Balance sheet below.

Liabilities total:  $8,938,000 
Assets total: $22,075,000

Total debt-to-asset ratio
     = Total liabilities / Total Assets   
     = $8,938,000 / $22,075,000
     = 0.405

The result 0.405 means that  creditors supply 40.5% of the company's funding. And, this means of course that owners supply the remaining 59.5%.

Total Debt-to-Assets Ratio Rule of Thumb.

When a firm approaches lenders asking for still more funding, potential creditors will compare the debt/assets ratio to the industry average. They will probably also compare the firm's debt/equity ratios (steps 2 and 3, below) with industry averages. If these ratios seem exceptionally high, lenders may require the firm to raise more equity capital before lending. This is because increasing equity capital does the following:

  • Raises the asset base.
  • Lowers the debt ratio.
  • Provides greater security for lenders if the business fails.

Measuring Leverage Step 2
Calculate and Interpret the Total Debt-to-Equity Ratio

Leverage is the use of borrowed funds to increase earnings
 

Bank loans are a primaryr source of debt funding that firms in private industry use for creating leverage. The firm's creditors—banks and bondholders—share business risks and rewards with shareholder owners.

Describe the firm's financial structure with a single ratio

Debt to equity ratios measure leverage levels directly. These ratioss mirror the textbook definition of leverage—they simply compare owner funding contributions directly to creditor contributions.

Two debt to equities ratios are especially important.

  • Firstly, the Total debt to-equities ratio (this section, Step 2).
  • Secondly, the Long-term debt-to-equities ratio (next section, Step 3).

Analysts regard the Total debt-to-stockholders-equities ratio as the stronger of these. This is because the ratio using "total debt" provides a more conservative view of creditor protection. By contrast, The Long-Term debt-to-equities ratio simply compares the two Balance sheet entries in its name by using them in a ratio.

Note that total liabilities means the sum of both long-term and short-term debt. "Debt" for this ratio therefore includes long term-loans, for acquiring assets, but also short term-debts the firm owes to suppliers, employees, and tax authorities. In addition, short term debt also includes interest payments due in the current period.

Analysts view the Total debt-to-equities ratio measure of leverage as a stand-in for the term financial structure. Financial structure is simply another name for a comparison of total debt funding to equity funding.

See the article Capital and Financial Structure for examples showing how to use Debt/Equity ratios to forecast the impact of leverge on gain or loss of earning power.

Calculating the Total Debt-to-Equities Ratio.

The ratio name describes the calculation. Note that this example uses figures from the Exhibit 3 Balance sheet below.

Liabilities total:  $8,938,000 
Stockholders equities total: $13,137,000
Total debt to equities ratio
     = Total liabilities / Total stockholders equities
     = $8,938,000 / $13,137,000
     = 0.680

Measuring Leverage Step 3
Calculate the Long Term Debt to Equities Ratio

The company's debt includes interest and payoff due bondholders
 

Bond sales sometimes provide the means for funding new ventures or business expansion. In 1954, for instance, Disneyland start up required two multimillion dollar bond sales. Bondholders in such cases keep a close watch on the firm's debt-to-equities ratiios, to ensure protection for their investments.

Describe the firm's captial structure structure with a single ratio

The second debt-to-equities ratio, Long-term debt-to-stockholders-equities (or simply Long- term debt-to-equities) is a truer measure of leverage than the ratio above in Step 2.

That is because the debt figure here includes only debt to lenders, or long term debt. By contrast, the total debt figure above also includes short term debt, such as wages the firm owes to employees or Accounts payable the firm owes to its suppliers.

As a result, this ratio equates to the firm's capital structure. This is because capital structure simply refers to a comparison of long-term debt to equity funding. Here, "debt" refers mostly to loan debt for acquiring income-earning assets.

See the article Capital and Financial Structure for examples showing how to use Debt/Equity ratios to forecast the impact of leverge on gain or loss of earning power.

Calculating the Long-Term Debt-to-Equities Ratio

The ratio name describes the calculation. Note also that this example also uses figures from the Exhibit 3 Balance sheet below.

Long term liabilities total: $5,474,000 
Stockholder's equities total: $13,137,000
Long-term debt-to-equities ratio
     = Total long-term liabilities / Total stockholders equities
     = $5,474,000 / $13,137,000
     = 0.417

Two Debt-to-Equities Ratios, Same Rules of Thumb

In summary, the Long-term debt-to-equities ratio represents the firm's capital structure, while the Total debt-to-equities ratio represents its financial structure. Both structures compare the firm's equity funding to its debt funding.

Averages for both debt to equities ratios vary widely between industries and between companies.

  • Many firms in capital asset-intensive industries such as heavy manufacturing, purchase assets primarily with borrowed funds. This often leads to debt/equity ratios greater than 1.0. In some cases, these ratios may be as high as 2.0 – 4.0.
  • In less capital intensive industries, such as the technology industries, funding typically comes primarily through equity sales and retained earnings. Here, debt/equity ratios are more often on the order of 0.2 – 0.5.

When a firm with substantial debt approaches a creditor, asking for still more funding, lenders normally consider several factors immediately:

  • Potential lenders compare the firm's total debt-ratio and its two debt-to-equities ratios to industry standards.
  • They also consider carefully the individual sources of existing debt, including actual costs of debt service.

In such cases, lenders will also focus on two kinds of questions.

  • Firstly, can the firm add more debt and still continue to service its debt? And, can it do so, even if the economy worsens, or business performance weakens?
  • Secondly, does the firm have enough collateral to protect lenders in case the business fails?

Measuring Leverage Step 4
Calculate and Interpret the Equity-to-Assets Ratio

The equity-to-assets ratio is another direct measure of leverage.
 

Investors know that shares in airline ownership are risky. Individual carriers face intense competion, ever-increasing fuel and labor costs, and stringent environmental regulations. To acquire aircraft, they take on complex financing schemes involving leasing, bank loans, bond sales, and outright purchase. It is no surprise that airline ventures often fail and go into liquidatation. Investor-owners watch always for changes in company financial position and prospects for financial performance. The equity-to-assets ratio is center stage for investors, who monitor carefully the firm's debt levels and ability to pay owners in case of liquidation.

Is the firm carrying too much or too little debt?

The Equity-to-assets ratio is one more rather direct measure of leverage. This metric makes a ratio of the two Balance sheet figures in its name to show the proportion of total assets that have equty funding.In other words, tequity-to-assets ratio provides a direct answer to the question: What proportion of the firm's assets to owner-investors own.

Investors view the equity-to-assets ratio as an indicator and decision guide for three issues that concern them. The ratio serves as:

  1. Another measure of leverge. The lower the ratio, the greater the level of leverage.
  2. An indicator that the firm may be carrying too much debt or too little debt.
  3. Another indicator (besides the Debt/Asset ratio) that indicates the extent to which owner investments are at risk in case the company fails and goes into liquidation.

Note that the Equity-to-assets ratio is the complement to Leverage Metric in Step 1 above, the Debt-to-assets ratio. The complementary relationship between the Step 1 ratio and the Step 4 ratio is simply:

Equity-to-assets complement
       = (1.0 - Total Equities) / (Total Assets)

The complement, of course, refers to funds not coming from owners. As a result, the complement refers to funds from lenders.

Calculating the Equity-to-Assets Ratio.

The ratio name describes the calculation. Note also that this example uses figures from the sample Balance sheet below.

Assets total:  $22,075,000 
Stockholders equities total: $13,137,000
Equities to assets ratio
     = Total equities / Total assets
     = $13,137,000 / $22,075,000
     = 0.595 or 59.5%

Thus, 59.5% of the company's assets funding comes from equities. The complement of this figure shows the funding percentage from creditors.

Equity to assets ratio complement
     = 1.0 - Equity / Assets
     = 1.0 – 0.405
     = 0.405 or 40.5%.

Equity-to-Assets Rules of Thumb

Investment analysts will compare the company's equity/assets ratio with the ratios of other companies in the same industry. Here, they will classify the ratio either as good, barely acceptable, or poor. The real question is whether the firm is carrying too little debt or too much debt:

  • Too much debt, means the company risks being unable to pay interest due for bank loans and bonds.
  • Too little debt, means the company may be missing opportunities to leverage growth with borrowed funds.

To fully evaluate the firm's equity/asset ratio, analysts will try to assess the business risk and financial risk facing Grande at this level of leverage. They will also consider carefully Grande's growth prospects for growth.

Measuring Leverage Step 5
Calculate and Interpret Times-Interest-Earned

When a high leverage company attempts to borrow still more, potential lenders turn to lverage metrics to decide whenter the customer can manage additional debt.
 

The banking business is all about earning and paying interest. When a high-leverage firm tries to borrow still more funds, potential lenders probe thoroughy the firm's ability to service additional debt. The times-interest-earned metric is central to this investigation..

Can the company still service its debt if its earnings decrease?

The times-interest-earnedmetric addresses this question. As a result, this metric represents a measure of the firm's credit worthiness. 

The Times-Interest-Earned metric is a simple ratio of two Income statement figures. Here, an "Income" figure is simply divided by interest expense. Note that the "income" figure for the Times-Interest-Earned metric does not reflect expenses for extraordinary items or taxes.

Calculating-Times-Interest Earned.

Note especially that the Exhibit 2 Income statement below provides data for this example,

Earnings before tax
     and extraordinary items: $2,737,000
Interest expense: $511,000

Times-Interest-Earned 
     = Earnings before tax and extraordinary items
                + interest expense) / interest expense
     = ($2,737,000 + $511,000 ) / $511,000
     = 6.36

Notice that the Income statement figure for "Earnings before tax and extraordinary items" already omits interest expense. The numerator of this ratio, therefore, adds back interest expense.

Times-Interest-Earned Rules of Thumb.

Potential lenders will read the firm's times-interest earned ratio in context with its overall financial position. Their primary concern is whether or not the firm can service additional interest payments and still make acceptable profits. In this regard, the generally prefer a higher ratio over a lower ratio. An extremely high ratio, however, may indicate that the company is missing opportunities to use leverage.

Example Income Statement
Including Input Data For Leverage Metrics

The example Income statement below in Exhibit 2 provides data for one of the leverage metrics above: Times-interest-earned.

Grande Corporation                                   Figures in $1,000's
Income Statement for Year Ended 31 December 20YY   
Revenues
Gross sales revenues
   Less returns & allowances
      Net sales revenues
Cost of goods sold
   Direct materials
   Direct labor
   Manufacturing Overhead
      Indirect labor
      Depreciation, mfr equipment
      Other mfr overhead
      Net mfr overhead
         Net cost of goods sold
Gross Profit








5,263
360
  4,000


33,329
    346


6,320
  6,100




 9,623



32,983








 22,043
 10,940
Operating Expenses
Selling expenses

   Sales salaries
   Warranty expenses
   Depreciation, Store equip
   Other selling expenses
          Total selling expenses
General & Admin expenses
   Administrative salaries
   Rent expenses
   Depreciation, computers
   Other general & admin expenses
      Total general & admin exp
           Total operating expenses
Operating Income Before Taxes
  

  4,200
  730
  120
   972


1,229
180
179
   200






6,022





  1,788













  7,810
  3,130
  Financial revenue & Expenses
  Revenue from investments
      Less interest expense
      Net financial gain (expense)
  Income before tax & ext items
  Less income tax on operations
    Income before extraordinary items
 



118
  511



  (393)
 2,737
  958
1,779
Extraordinary Items
   Sale of land
   Less initial cost
      Net gain on sale of land
      Less income tax on gain
         Extraord items after tax
 
610
  145



465
  118





  347
Net Income (Profit)       2,126
 

Exhibit 2. An Example Income statement with data for the leverage metric Times-interest-earned.

Example Balance Sheet
Including Input Data For Leverage Metrics

The example Balance sheet in Exhibit 3 below provides data for leverage metrics.

Grande Corporation                                   Figures in $1,000's
Balance Sheet at 31 December 20YY   
ASSETS
Current Assets
   Cash
   Short term investments
   Accounts Receivable
      Less allowance doubtful accts
      Net accounts receivable
   Notes receivable short term
   Inventories
      Raw materials
      Work in progress
      Finished goods/merchandise
      Operating & office supplies
            Total Inventories
   Prepaid exp, insurance, def taxes
          Total Current Assets




1,969
   137



    611
1,692
3,664
      19


1,369
  137


1,832
     20





5,986
  265
















9,609
Long Term Investments and Funds
   Common stock held
   Preferred stock held
   Bonds Held / Sinking funds
   Other Long Term Investments
          Total Long Term Investments
    
  493
  184
  364
  419





1,460
Property, Plant & Equipment
   Factory Manufacturing Equipment
      Less accumulated depreciation
      Net factory mfr equipment
   Store Equip / Selling Assets
      Less accumulated depreciation
      Net store/selling equipment
   Computer systems
      Less accumulated depreciation
      Net computer systems
           Total Property, Plant & Equip
 
5,983
 2,782

5,456
 1,292

4,721
 2,370




3,201

4,164


  2,351










9,716f
Intangible Assets
   Copyrights
   Trademarks and Patents
   Goodwill
          Total Intangible Assets
    
1,014
108
  100




1,222
Other Assets
                    Total Assets
         68
22,075
LIABILITIES
Current Liabilities
   Accounts payable
   Notes payable, short term
   Current portion of long term debt
   Accrued expenses, Interest payable
   Unearned revenues
   Taxes payable Other withholding
          Total Current Liabilities



 1,642
    912
    349
     146
     274
    141








3,464
Long Term Liabilities
   Bank notes payable
   Bonds payable, other LT liabilities
          Total Long Term Liabilities
                    Total Liabilities
     
912
 4,562



 5,474
8938
OWNERS EQUITY
Contributed Capital
   Preferred stock
   Common stock
   Contributed capital excess of par
          Total Contributed Capital

Retained Earnings
          Total Owners Equity


3,798
4,184
 1,457





9,439

 3,698








13,137
          Total Liabilities and Equities
    22,075
 

Exhibit 3. Leverage metrics take input data from this example Balance sheet.

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