Unlock Growth Potential: How to Utilize Leverage Ratios

A leverage ratio is a financial measurement that determines how much a business relies on debt for day-to-day capital. Your capital is the money you use to pay for the daily activities and operations necessary to run your business. Whether you pay for these activities out of pocket or via debt, the money used for business operations is called capital.

Knowing how much of your capital comes from debt can help you determine whether you can pay off those debts. Therefore, banks and lenders often use a leverage ratio to determine your ability to repay, along with other financial factors.

A high leverage ratio tells us that a company relies on debt as a large portion of its capital, making it a riskier investment for lenders because the more debt a company has, the less likely they are to pay it back. A high ratio may also indicate that a business has inconsistent revenues, so lenders or shareholders may not see a return on their investment quickly.

A low leverage ratio tells us that a company is financially responsible, relying more on equity than debt for daily business operations. Even if a business has debt, it’s not necessarily a bad thing, but a low ratio indicates that they’re more likely to repay that debt.

Why are leverage ratios important?

Leverage ratios are important financial metrics for business owners, investors, and lenders because they measure how much debt a business leverages for operations.

Debt is often necessary for businesses. Taking out a business loan can fuel growth, allowing businesses and investors to get higher returns. It can also help aid in financial survival during times of financial uncertainty, allowing businesses to continue paying their employees and producing products when they don’t have equity.

Companies can also use leverage ratios to determine how different changes within the business can affect operating expenses and income.

When looking for financing, either with investors or lenders, business owners typically have an elevator pitch to teach investors about what the business does and a pitch deck to encourage them to buy into their businesses. Your pitch deck should include important financial information about the business to help investors understand whether it’s a good investment.

These pieces of financial data should include everything from inventory turnover ratio to sales metrics and internal financial information. Including the various leverage ratios can help them easily understand how much debt you use to finance daily operations and determine their level of risk, affecting whether or not your business can secure funding.

There are several leverage ratios that can help you compare your capital to debt. One of the easiest to understand is the debt-to-asset leverage ratio which determines how much debt you use to finance business assets.

To measure your debt-to-asset ratio, you can use the following leverage ratio formula:

total debt/total assets

Your total debt should include all debts, including short and long-term debts ranging from credit cards to business loans.

By calculating this leverage ratio, you can determine how financially stable your business is and decide whether you can or should take out another loan. A high debt-to-asset leverage ratio could mean you won’t be able to maximize your ROI because you’re at a higher risk of defaulting on your loans.

Types of leverage ratios

There are several different types of leverage ratios you can use in different scenarios. Market analysts, investors, and lenders may use one or more of them to determine the business’s financial health.

Unfortunately, there’s no single ideal leverage ratio because it’ll vary based on the type of ratio you use. Higher leverage ratios can be better in some cases, so it’s important to understand the different types of leverage ratios and when to use them.

Debt-to-equity ratio

The debt-to-equity leverage ratio compares the business's debt to equity or overall business value. You can find your debt-to-equity ratio using this formula:

debt/equity

A high debt-to-equity ratio tells you that the company finances its growth using debt, which can be risky. If you have a high debt-to-equity ratio, you should know how to deal with potential business risks associated with taking on too much debt and ensure you can always repay your debts on time.

Taking on too much debt can result in default or bankruptcy, so businesses should avoid a high debt-to-equity ratio.

Operating leverage ratio

The operating leverage ratio formula measures fixed to variable costs and how they affect net operating income. For instance, this leverage ratio can be used to determine the percentage change in revenue from changes in the number of sales or sales values. The formula for the operating leverage ratio is:

% change in earnings before interest & taxes (EBIT)/ % change in sales

Net leverage ratio

The net leverage ratio, also known as the debt to EBITDA leverage ratio, can be used by business owners to determine their borrowing capacity by measuring their earnings before interest, taxes, depreciation, and amortization (EBITDA) versus net debt. The formula for this type of leverage ratio is:

net debt-cash holdings/EBITDA

This information can tell you how long it takes to pay back debt if it remains constant.

Debt-to-EBITDA ratio

The Debt-to-EBITDA ratio is similar to the net leverage ratio. However, it factors in EBITDA before exploration costs (X).

With this ratio, business owners can calculate their leverage ratio if they have exploration or research costs. Most business owners won’t need to use this ratio because they don’t have exploration costs.

The formula to calculate this leverage ratio is:

net debt - cash holdings/EBITDAX

To find your EBITAX, you add exploration expenses to your EBITDA.

Debt-to-capital ratio

The debt-to-capital ratio measures how company operations are financed, taking into account all forms of debt. This is one of the most known leverage ratios because it determines a direct relationship between debt liabilities and capital, including shareholder equity.

The debt-to-capital leverage ratio formula is:

debt/(debt + shareholder equity)

Companies with a high debt-to-capital leverage ratio are typically seen as riskier investments because they require more debt to finance their operations.

Debt-to-capitalization ratio

The debt-to-capitalization ratio measures the amount of capital a company raises from all types of debt, including short and long-term debt, and compares it to the company’s total equity. The formula for this ratio is:

debt/(debt + equity)

This formula tells you the amount of money raised to purchase business assets, including taking on debt or selling shares. With this formula, you can see the total amount of capital raised for a company.

Interest coverage ratio

The coverage ratios we’ve discussed so far typically deal with changes in earnings before interest and taxes. However, not factoring in the cost of interest means not having the whole financial picture of how much debt your business uses to finance operations.

The interest coverage ratio helps determine a company’s ability to pay its debts, including interest. You can calculate this leverage ratio with the following formula:

Operating income/interest expenses

The higher your leverage ratio is here, the better because it means you’re more likely to be able to repay your debts.

Fixed-charge coverage ratio

The fixed-charge coverage ratio measures the company’s ability to pay fixed debt obligations from earnings before interest and taxes (EBIT). These fixed charges include leases, mortgage payments, other loan payments, and any other fixed expenses you pay for using debt.

To calculate it, you can use this formula:

EBIT/interest expense

The fixed-charge coverage ratio only factors in long-term debt, allowing you to measure cash flow versus interest owed.

Leverage ratios calculate a business’s use of debt to maximize ROI. There is no single best type of leverage ratio. Instead, this term refers to the various different types of financial leverage ratios that compare a business’s debt, assets, and operational costs.

Simply put, they determine how much capital comes in the form of debt, which can help investors or lenders determine a company’s level of risk. These ratios tell investors or lenders whether companies can pay their debts on time based on earnings and other financial factors.

At the same time, leverage ratios help companies determine whether they should take on more debt. Many companies use debt to fuel growth because it’s less costly than equity financing, so they’ll need to know whether their business can fulfill its financial obligations.

Utilize leverage ratios for future business success

Leverage ratios can help you determine whether to take on more debt to unlock your business’s growth potential. Every business that needs funding or wants to better understand its financial health should know its leverage ratios to ensure it can repay its debts while supporting overall business growth.

Of course, running a successful business includes more than just its finances. Marketing can play a role in the health of your business while supporting financial goals by reducing expenses and costs to acquire and retain customers.

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