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