Leverage metrics / Leverage
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2011 by Marty J.Schmidt. Revised 20 April 2012.
The Meaning of Financial Leverage Metrics
Financial Leverage metrics compare the funds supplied to a company by creditors to the funds supplied by the company's owners. Risks of the enterprise are borne both by creditors and owners, but in proportion to their share of the funding. If creditors have provided most of the funding, they have more to lose than the owners if the business fails.
This entry illustrates four of the most commonly used financial leverage metrics, including the total debt to asset ratio (or debt ratio), total debt to equities ratio, long term debt to equities ratio, and times interest earned.
Financial Leverage metrics also compare the costs and returns of creditor supplied funds with the returns on owner supplied funds. In a strong economy or when the business is otherwise doing well, owners may make more on creditor supplied funds than they pay for the cost of borrowing. However, the reverse can be true in a poor economy or if the company starts performing poorly for other reasons: in those cases, earnings may not be high enough to justify the cost of funding (interest payments on the borrowed funds), and the borrowing costs fall especially heavily upon the owners.
Note that the leverage metric Long term debt to equities ratio can be thought of as a primary measure and descriptor of a company's capital structure, whereas the Total debt to equities leverage may be considered a measure of a company's financial structure. Both "structures" compare the company's equity funding to the its debt funding.
The leverage metrics examples below use data from the sample income statement and balance sheet, also included below.
For a more complete summary of leverage metrics, along with working spreadsheet examples integrated with source financial statements and a complete range of other financial metrics, see Financial Metrics Pro.
• Four Financial Leverage Metrics
– Total Debt to Asset Ratio or Debt Ratio
– Debt to Equity Ratios
- Total Debt to Equities Ratio
- Long Term Debt to Equities Ratio
– Times Interest Earned
• Sample Income Statement
• Sample Balance Sheet
[ Page Top] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
Four Financial Leverage Metrics
Total Debt to Asset Ratio or Debt Ratio
What proportion of the company's total funding is provided by creditors? The total debt to assets ratio metric addresses this question. This metric compares two balance sheet entries, total liabilities (i.e., total debt) and total assets.
How is the total debt to assets ratio (Debt ratio) calculated?
This example uses the following data from the sample balance sheet below;
Total liabilities: $8,938,000
Total assets: $22,075,000
Total debt to asset ratio, or Debt ratio
= Total liabilities / Total Assets
= $8,938,000 / $22,075,000
= 0.405
The example result 0.405 means that 40.5% of the company's funding has been supplied by creditors.
Total debt to asset ratio or debt ratio rule of thumb :
If the company needs to approach creditors for still more funding, potential lenders will very likely compare this debt ratio to the industry average. If the value is above the industry average, potential creditors may require the company to raise more equity capital before lending (thus raising the asset base, lowering the debt ratio, and providing more security for lenders if the business fails).
[ Page Top] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
Debt to Equities Ratios
Debt to equity ratios measure the extent to which owner's equities can protect creditors' claims, should the business fail.
Total Debt to Equities Ratio
The first of these debt to equity ratios, total debt to stockholders' equities, is the strongest of these measures, that is, it provides the most conservative view of creditor protection. This ratio compares two balance sheet entries, Total stockholders equities and Total liabilities.
How is the total debt to equities ratio calculated?
The corresponding figures for this example from the sample balance sheet below are:
Total liabilities: $8,938,000
Total stockholders equities: $13,137,000
Total debt to equities ratio
= Total liabilities / Total stockholders equities
= $8,938,000 / $13,137,000
= 0.680
Long Term Debt to Equities Ratio
The second debt to equities ratio, long term debt to stockholders equities (or more simply long term debt to equities) is more properly a measure of leverage, because the debt figure contains only debt to lenders, or long term debt, (as opposed to total debt, which includes debt to vendors, employees, and tax authorities as well as debt to lenders).
It is apparopriate to view the long term debt to equities ratio as a measure of what is called the company's capital structure—a comparison of the company's debt funding to its equities funding. "Funding" in this sense has in mind funds used to acquire income-earning assets, which are likely to include long term debt but not short term debt. (Short term debt usually represents obligations such as "Employee salaries owed," "Accounts Payable," and "Taxes due.")
How is the long term debt to equities ratio calculated?
The corresponding figures for this example are from the sample balance sheet below are:
Total long term liabilities: $5,474,000
Total stockholder's equities: $13,137,000
Long term debt to equities ratio
= Total long term liabilities / Total stockholders equities
= $5,474,000 / $13,137,000
= 0.417
Debt to equities ratios rules of thumb:
- Average debt to equities ratios vary widely between industries, and between companies within industries. Potential lenders and investors will compare a company's debt to equities ratios to industry standards, but will also consider carefully the individual sources of the existing debt as well, including actual costs of debt service. In other words, potential investors and lenders will consider the risks associated with existing debt as an important factor in addition to the debt to equity ratios themselves.
- In capital asset-intensive industries (such as heavy manufacturing), the majority of funds used to acquire product assets are obtained through borrowing, leading to debt/equity ratios greater than 1.0 (and in some cases as high as 2.0-4.0). In less capital intensive indusitries—for example, the technology industries—the majoroity fo funding typically comes through equity sales and retained earnings, leading to debt/equity ratios on the order of 0.2-0.5. Potential lenders generally consider debt/equity ratios well over the industry standards as an indication that the company is a risky loan prospect.
[ Page Top] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
Times Interest Earned
Can the company still meet interest charges if earnings decrease? The times interest earned metric addresses this question. This is considered a measure of the credit worthiness of the company.
Times interest earned is based on income statement terms: the company's earnings before extraordinary items, interest and taxes are compared to the company's interest expenses.
How is times interest earned calculated?
Data for an example calculation are taken from the sample income statement below:
Earnings before tax and extraordinary items: $2,737,000
Interest expense: $511,000
Times Interest Earned
= Earnings before tax and extraordinary items + interest expense) / interest expense
= ($2,737,000 + $511,000 ) / $511,000
= 6.36
Notice that the income statement figure for "Earnings before tax and extraordinary items" has already had interest expense subtracted. The total in the upper portion of this ratio, therefore, has the interest expense added back, before the upper portion is divided by the same interest expense figure.
Times interest earned rules of thumb:
Potential lenders will interpret the company's times interest earned ratio in the context of it's overall financial position, to help decide whether or not it can service additional interest payments and still make acceptable profits. In this regard, a higher ratio is generally preferred over a lower ratio. An extremely high ratio, however, may indicate that the company is not leveraged enough to take advantage of current opportunities.
[ Page Top] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
Sample Income Statement
Some of the data for leverage metrics examples above were taken from this example income statement.
Grande Corporation Gross sales revenues.................33,329 Gross profit.................................10,940 Operating expenses Operating income before taxes............... 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit).......................... 2,126 |
[ Page Top] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
Sample Balance Sheet
Some of the data for leverage metrics were taken from this example balance sheet.
Grande Corporation Assets Liabilities Owners Equity |
For a complete introduction to financial metrics, including a working set of interrelated financial statements and over 150 financial metrics derived from them, see Financial Metrics Pro.
[ Page Top] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
© Copyright Solution Matrix Ltd and 
Marty J. Schmidt+ 2004 - 2012. Legal notice. Unauthorized use or publication strictly prohibited under United States and International Copyright Law. Request permission to use.
Solution Matrix Ltd
Solution Matrix Germany
Solution Matrix Asia
Solution Matrix Pacific