Financial Leverage Ratio Analysis Example & Formula

Financial leverage ratios are crucial for assessing a company's financial structure, risk, and ability to meet its long-term obligations. These ratios analyze the relationship between a company's debt and equity, offering insights into how much debt a company is using to finance its operations and growth. They are essential for understanding whether a company is over-leveraged, operating sustainably, or managing its debt efficiently. Investors, creditors, and financial analysts rely on these ratios to gauge a company's financial stability, its ability to handle debt, and its capacity to generate sufficient income to meet its obligations.

Below are some of the most important financial leverage ratios:

1. Debt to Equity Ratio

The debt to equity ratio is one of the most commonly analyzed financial leverage ratios, measuring the proportion of a company’s total debt relative to its shareholder equity. This ratio is important because it helps assess how much of the company’s financing comes from debt as opposed to equity.

A high debt to equity ratio indicates that a company is heavily reliant on debt to finance its operations. While this can enhance returns in favorable conditions, it also increases financial risk, as the company must generate enough revenue to cover its debt obligations.

A low debt to equity ratio suggests that a company relies more on equity financing, which typically indicates lower financial risk and greater stability, as it does not have the same level of debt obligations.

Investors and creditors use this ratio to assess the risk associated with lending or investing in a company, as high leverage can increase vulnerability during downturns or periods of low revenue.

2. Total Debts to Assets Ratio

The total debts to assets ratio measures the proportion of a company’s total assets that are financed through debt. It provides insight into the financial stability of the company by reflecting its reliance on debt to support its asset base.

A higher ratio suggests that a company relies more on borrowed funds, which could lead to greater financial risk.

A lower ratio indicates that the company is financing its assets through equity, suggesting greater financial stability and less reliance on creditors.

This ratio is often used by investors and lenders to evaluate a company’s ability to meet long-term obligations and to compare companies within the same industry.

3. Interest Coverage Ratio

The interest coverage ratio measures a company’s ability to pay its interest expenses using its earnings before interest and taxes (EBIT). It’s a key indicator of a company’s ability to meet interest payments without financial strain.

A high interest coverage ratio indicates that the company can comfortably meet its interest obligations, signaling strong profitability and lower risk of default.

A low interest coverage ratio suggests that the company may have difficulty generating enough earnings to cover its interest payments, which increases the risk of default and financial instability.

This ratio is closely watched by lenders as it reflects a company’s creditworthiness and capacity to service its debt.

4. Debt Service Coverage Ratio (DSCR)

The debt service coverage ratio evaluates a company’s ability to meet its debt obligations, including both interest and principal repayments, using its net operating income. It is crucial for assessing how well a company generates income to cover its debt payments.

A higher DSCR indicates that the company generates sufficient operating income to comfortably meet its debt obligations, signaling financial strength.

A lower DSCR suggests that the company may not be generating enough income to meet its debt payments, which increases the likelihood of default and financial instability.

Creditors often use this ratio to assess a company’s ability to repay loans over time and to determine loan eligibility.

5. Capitalization Ratio

The capitalization ratio evaluates the proportion of a company’s long-term debt in relation to the combined value of its long-term debt and shareholder equity. It provides insight into the company’s overall financial structure.

A higher capitalization ratio suggests that the company is more reliant on long-term debt for financing, which may indicate higher financial risk.

A lower capitalization ratio indicates that the company is relying more on equity, which typically suggests lower financial risk and greater stability.

The capitalization ratio helps investors and lenders understand a company’s financial leverage and risk profile, as well as its ability to meet long-term obligations.

Conclusion

Financial leverage ratios are essential tools for evaluating a company’s financial health, stability, and risk. These ratios provide a comprehensive view of a company’s use of debt to finance its operations and growth, highlighting the company’s ability to manage debt, its financial risk, and its capacity to meet long-term obligations. Here's a quick recap of the key leverage ratios:

Debt to equity ratio: Measures a company’s reliance on debt versus equity.

Total debts to assets ratio: Reflects the company’s reliance on debt to finance its assets.

Interest coverage ratio: Indicates the company’s ability to cover interest expenses with earnings.

Debt service coverage ratio: Evaluates the company’s ability to meet both interest and principal payments.

Capitalization ratio: Assesses the proportion of long-term debt relative to equity in the company’s financial structure.

By analyzing these ratios, stakeholders can gain valuable insights into a company’s financial strategies, risk levels, and overall stability. However, it’s important to consider these ratios in context, taking into account industry norms, economic conditions, and the company’s specific financial situation. A balanced approach to leverage can help a company grow while maintaining the financial flexibility needed to navigate economic challenges.

Formula:
1) Debt to Equity = Total Debt / Total Equity
2) Total Debts to Assets = Total Liabilities / Total Assets
3) Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Charges
4) Debt service coverage ratio = Net Operating Income / Total Debt Service
5) Capitalization Ratio = Long-term Debt / (Long-term debt + Shareholder equity)

Learn how to calculate financial leverage ratio with the following examples:

Example 1:
CK Ltd has total liabilities of $700,000 and total stockholders' equity of $380,000, then the debt/capital ratio is: 700,000 / (700,000 + 380,000) = 700,000 / 1,080,000 = 0.6481 = 64.81%

Example 2:
Saint Ltd. is looking at an investment property with a net operating income of $87,000 and an annual debt service of $58,000. The debt service coverage ratio for this property = 87,000 / 58,000 = 1.5

Example 3:
Jimmy plc has total sales revenue of $99,000 for the year. It has cost sales $9,000 and operating expenses of $5,000. The company's interest expense for the year is $25,000.
Then,
Earnings Before Interest and Taxes = Sales – Cost of sales – Operating expenses
EBIT = $99,000 - $9,000 - $5,000
EBIT = $85,000
Interest Coverage Ratio = $85,000/$25,000 = 3.4 times

Example 4:
Peters Ltd has the following information:
Creditors $2,000
Loan $38,000
Buildings $60,500
Debtors $7,000
Bank $5,000
Stocks $4,500

Then, the Total Liabilities = 2,000 + 38,000 = $40,000
Total Assets = 60,500 + 7,000 + 5,000 + 4,500 = $77,000
Total Debts to Assets = 40,000 / 77,000 = 0.519