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Leverage and Financial Leverage Metrics
Definition, Meaning Explained, Example Calculations

 

Leverage metrics compare the firm's creditor-supplied funds to its owner-supplied funds. 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 metrics compare the funds supplied to a firm by creditors to the funds supplied by owners. If creditors provide more funding than owners, the firm is said to be highly leveraged.

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 would a profitable firm borrow funds when it 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 borrowed funds 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 for borrowed funds. In this case, borrowing costs are therefore especially burdensome for owners. This is because leverage decreases earning power when business is poor.

Leverage metrics compare the costs and returns of funds from both sources—debt funding and equity funding. As a result, 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.

Capital Structure and Financial Structure

Note that the leverage metric Long term debt to equities ratio 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.

This article further explains and illustrates the debt to equities ratios, along with three other frequently used ratios—leverage metrics—that also compare the firm's funding sources. Leverage metrics appearing below include the following:

  • 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


 

The Role of Leverage and Other Financial Metrics (Business Ratios)

Leverage metrics are a financial metrics family—one of six metrics families called financial statement metrics. In general, these metrics draw 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: 

Exhibit 1. The firm's four financial statements provide most of the input data for profitability metrics.

Some businesspeople refer to all financial statement metrics as "business ratios." That is because most of these metrics are in fact calculated by dividing one financial statement figure into another. Note especially, 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.

What Are the 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?

The remainder of this article illustrates 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.

Frequently Used Financial Leverage Metrics

The sections below present five leverage metrics frequently used in business today. The text explains the essential meaning of each metric, presents example calculations, and discusses "rules of thumb" for interpreting metrics results.

Note that most input data for example calculations are taken from the Exhibit 2 Income statement and the Exhibit 3 Balance sheet lower on this page.

 

Financial Leverage Metric 1
Total Debt to Assets Ratio (Debt Ratio)

What proportion of the company's total funding is provided by creditors?

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.

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 Asset Ratio Rule of Thumb.

When a firm approaches lenders asking for still more funding, potential creditors will compare this debt ratio to the industry average. They will probably also compare the firm's debt/equity ratios (described below) with industry averages. As a result, 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.

Financial leverage metric 2
Total debt to equities ratio

Can the firm's equities protect creditors if the business fails?

Debt to equity ratios measure the extent to which owner's equities can protect creditor claims, should the business fail. Two debt to equities ratios are especially important.

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

Total debt to stockholders' equities is said to be the stronger of these. This is because the ratio using "total debt" provides a more conservative view of creditor protection. The total 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 and short term debt. "Debt" for this ratio therefore includes long term loans, for acquiring assets, but also short term debts owed suppliers, employees, and tax authorities. In addition, short term debt also includes interest payments due in the current period.

As a result, the total debt to equities ratio equates, rightfully, with the term financial structure. This is simply another name for a comparison of total debt funding to equity funding.

Calculating the Total Debt to Equities 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 
Stockholders equities total: $13,137,000

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

Financial Leverage Metric 3
Long Term Debt to Equities Ratio

Can the firm's equities protect creditors if the business fails?

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 immediately above. 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 can be called, rightfully, 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 borrowed funds used to acquire income-earning assets.

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

Debt to Equities Ratios 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 debt ratio and 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?

Financial Leverage Metric 4
Equity to Assets Ratio

Can the firm's equities protect creditors if the business fails?

The Equity to assets ratio is one more rather direct measure of leverage. Remember that firms can purchase assets with funds from either sources, equities or borrowed funds. This metric, therefore, makes a ratio of the two Balance sheet figures in its name to show the proportion of total assets funded by equities.

Note that the Equity to assets ratio is the complement to leverage metric 1, above, the Debt to assets ratio. Debt to assets, computed as a complement to Equity to assets, is simply:

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

The complement, of course, refers to funds not provided by 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%

Grande's assets are funded 59.5% by 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 Grande'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 Grande 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 Grande's equity / asset ratio, analysts will try to assess the business risk and financial risk that Grande is exposed to at this level of leverage. They will also consider carefully Grande's growth prospects for growth.

Financial Leverage Metric 5
Times Interest Earned

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

The times interest earned metric addresses this question. As a result, this metric is 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" has already had interest expense subtracted. 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, a higher ratio is generally preferred over a lower ratio. An extremely high ratio, however, may indicate that the company is missing opportunities to use leverage.

Example Income Statement 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
   Dirct 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 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










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




1,460
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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