What are the Types of Leverage Ratios?

Finance ManagementBanking & FinanceGrowth & Empowerment

Purpose of Leverage Ratio Calculation

To determine the long-term financial position of a company, its financial leverage is calculated. The method of increasing shareholder’s return using debt is known as Financial Leverage. Leverage ratios are, thus, connected to the processes where debt is used to magnify the shareholder’s returns.

In fact, excessive debt is a risky proposition for a firm. It has to pay interests to the lenders when a firm acquires debt. Moreover, the debt providers may also ask for payment when the pre-set duration of lending ends. A firm is obligated to pay the lender's amount back within a specified period of time. The debtors may force it for payment and in extreme cases, a firm may be liquidated to meet the debtor's amounts.

Therefore, firms must always stay aware of their debt situations. Leverage ratios are helpful in offering a nice view of the overall debt burdens of a company. That is the reason why the leverage ratios are so important. They not only provide information about the proportion of debt in the capital structure, but also help firms reduce future risks by signaling the dangers, if any.

Types of Leverage Ratios

Following are the Various Types of Leverage Ratios −

Debt Ratio

There are more than one debt ratios to measure the overall debt position of a firm. Analysts and investors often tend to know the proportion of the interest-bearing debt in the capital structure of a project.

The debt ratio may, therefore, be calculated by dividing Total Debt (TD) by Capital Employed (CE) or Net Assets (NA).

The total debt contains all forms of debt, whether it’s short or long term. Therefore, we may include all types of borrowing from financial institutions, bonds, debentures, deferred payments, and arrangements made for buying equipment bank loans, public investments, and all other interest-bearing loans in calculating TD.

Capital Employed or CE will include Net Worth (NW) and Total Debt (TD).

$$\mathrm{Debt\:Ratio\:=\:\frac{Total\: Debt}{Total\: Debt\:+\:Net \:Worth}}$$

It is also found that Debt Ratio = Total Debt / Net Assets

Debt-to-Equity (D/E) Ratio

The ratio that describes the lender's contribution to each rupee of the owner’s contribution is called the debt to equity ratio. It is obtained by dividing total debt (TD) by Net worth (NW).

$$\mathrm{Debt \:Equity\:=\:\frac{Total \:Debt}{Net\: Worth}}$$

Other Ratios Related to Debt

It can be observed from the use of popular debt ratios that current liabilities or non-recurring short-term outflows of cash are omitted in the calculations. However, one may require to find them because they represent financial risks that may affect the operations and profitability of a firm.

Therefore, assessment of total funds–short and long-term–provided by outsiders, the Total Liabilities (TL) to Total Assets (TA) ratio may be calculated.

It is called TL to LF or Total Liabilities to Liquid Funds Ratio.

$$\mathrm{Total\: Liabilities \:to \:Liquid\: Funds\: Ratio\:=\:\frac{Total \:Liabilities}{Total \:Assetss}}$$

In addition to the above mentioned ratios, there are other ratios to calculate the Long-Term Capitalization or Funds (LTF) and Long-Term Debt (LD) to Net Worth (NW) Ratios.

$$\mathrm{LT-to-LF\: Ratio\:=\:\frac{Long-Team \:Debt}{Long-Term\: Debt\:+\:Net\: Worth}}$$ $$\mathrm{LT-to-NW \:Ratio\:=\:\frac{Long-Team\: Debt}{Net\: Worth}}$$

Conclusion

Companies need to have a good understanding of their debt cost. When the cost of debt is higher than the returns the company earns from its projects, it is a dangerous signal for the firm. Such a position implies that there is a shortage of funds for paying back the interests and principal payments of the debt resourced by the company.

By keeping an eye on the leverage ratio, a firm may skip the dangerous situations by taking corrective measures as and when required.

raja
Updated on 15-Apr-2022 12:39:20

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