Leverage Ratio
Financial Statement Analysis and the Leverage Ratio
| The leverage ratio uncovers all debt on the balance sheet. It is calculated by dividing total assets by owners equity. |
Calculating the Leverage Ratio
| Assets/Owner’s Equity |
The higher the leverage ratio, the more the company has used debt to finance its assets. Generally, ratios of higher than 15 are a warning signal. Low debt ratios compared to industry averages and competition, on the other hand, may indicate underutilized assets.
Debt Ratios and Financial Statement Analysis
In the days of Enron
The leverage ratio is therefore a handy financial tool because it captures all liabilities regardless of where they are listed.
The leverage ratio finds all debt by utilizing the accounting equation:
| Assets = Liabilities + Owners Equity |
The company either owns an asset (Assets = Owner’s Equity) or financed part or all of it (Assets – Liabilities = Owner’s Equity).
A leverage ratio of one equals no debt. For example, if the owner invested $50,000 to start a business in cash, the ratio = 1.
| 50,000/50,000 = 1 |
If the company then purchases machinery for $500,000 on loan, the ratio becomes 11.
| 550,000/50,000 = 11 |
In the example above, the business owns $50,000 of the total assets of $550,000, so the total debt must equal $500,000.
To add relevance to this number, compare the leverage ratio with competitors and industry averages. For example, capital-intensive industries like auto manufacturers have much higher leverage ratios, while the software industry, which requires much less capital investment, has lower leverage ratios.
| Company | Leverage Ratios |
| S&P 500 | 3.7 |
| Microsoft | 1.8 |
| Software Industry | 1.7 |
| Sunglasses Hut Int. (Luxottica Group) | 2.3 |
| Specialty Retail, Other | 1.6 |
| Sunny Sunglasses Shop | 1.5 |
Sunny Sunglasses Shop has fewer assets financed by debt than the industry average and its closest competitor, Luxottica Group.
A leverage ratio that is too low compared to industry averages may indicate that a company is not fully utilizing leverage to earn a profit.
If, for example, a business can borrow money at 6% to acquire assets that return 12%, borrowing funds for additional assets increases the net income and value of the business.
The company should earn enough on the investment to pay the debt charges from operating income and make a profit.
The interest coverage financial ratio can determine whether or not the company is earning enough operating income to cover debt interest expenses.
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