Leverage Ratios: Types & Formula

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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define leverage. We'll review three types of financial leverage ratios: debt ratio, debt-to-equity ratio, and interest coverage ratio. You'll also learn how to calculate and analyze the results.

What are Financial Leverage Ratios?

Computech has been in business for over 20 years. They have tried to remain current on their product offerings and invest in research and development. However, competitors are outperforming Computech's sales, and the executives would like to request a \$1 million business loan for new inventory, advertising and marketing.

The chief financial officer, Mark, applies for a business loan at Bank and Trust. The loan officer reviews Computech's financial information and tells Mark the company is highly leveraged.

The loan officer explains that leverage is a ratio of the company's debt and equity. Highly leveraged means that the company has taken on too many loans and is in too much debt. He goes on to say there are three financial leverage ratios the bank reviewed to determine the decision: debt ratio, debt-to-equity ratio and interest coverage ratio.

For the rest of this lesson, we'll review these three ratios and discuss how to analyze the results.

Debt Ratio

Financial leverage ratios compare how much debt a company has incurred in relation to assets, equity and interest. When companies want to expand, grow or invest in research and development, they have two main options: finance these initiatives with debt (loans from the bank) or equity (cash from selling stock to the public). We'll focus on Computech's use of loans first by calculating the debt ratio.

The debt ratio shows how well a company can pay their liabilities with their assets. Before further explaining the debt ratio, let's define liabilities and assets. Liabilities are obligations a company owes, such as a loan to purchase computer inventory. Assets are items owned by the company, such as the actual inventory. So, the debt ratio essentially tells us what percentage of the total assets are owed in loans.

To calculate the debt ratio we take total liabilities divided by total assets. If Computech has total assets of \$25,000 and total liabilities of \$17,500 (\$17,500/\$25,000), their debt ratio is 70%. This means Computech owns less of their assets than they owe. Banks like to see a debt ratio of 40% or less. They are interested in the company owning more of their assets possibly to use as collateral for a new loan. Now let's take a look at the debt-to-equity ratio.

Debt-to-Equity Ratio

Remember another way a company can finance their expansion, growth, research and development initiatives is to sell stock to the public. This is known as equity financing. The debt-to-equity ratio shows the percentage of financing that comes from banks or stockholders.

To calculate the debt-to-equity ratio, we take total liabilities divided by total equity. If Computech has total liabilities of \$17,500 and total equity of \$9,500 (\$17,500/\$9,500), their debt-to-equity ratio is 1.84.

The debt-to-equity ratio is a baseline ratio, meaning there is a minimum standard. If the ratio equals 1, Computech has equally financed their assets with debt and equity. If the ratio is lower than 1, Computech is financed more by stockholders or equity. If the ratio is higher than 1, Computech is financed more with debt. Since 1.84 is greater than 1, we can assume Computech is financed more with loans from a bank. Hence, another reason why the loan officer denied their loan request. Now let's review the interest coverage ratio.

Interest Coverage Ratio

The interest coverage ratio looks at the company from a different perspective. The interest coverage ratio compares Computech's earnings as it relates to their interest payments. It shows the company's ability to pay its interest payments. When a company seeks a loan from the bank, the bank charges the company a cost to loan the money, and that cost is called interest. Essentially, interest is what the bank receives to loan money.

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