What is Leverage Ratio in Finance?

Finance ManagementBanking & FinanceGrowth & Empowerment

What is Leverage Ratio?

Creditors and lenders invest money in a firm looking for returns at different points in time. Short-term creditors, such as bankers and raw materials suppliers are usually more interested in the short-term liquidity of the firms they invest in. On the other hand, the long-time creditors, such as debenture holders and institutional investors look for the long-term health of a firm.

In order to be termed healthy, therefore, a firm should be able to meet its short- as well as long-term obligations. To ascertain the long-term potential of a firm, financial leverage or capital restructure ratios are used. These ratios represent the contribution of funds from the lenders and the investors.

Leverage ratios are, thus, the ratios that show a firm’s leverage on borrowed funds from long-term investors. They are significant because they show the health of a firm on a long-term basis and help investors decide which form is a profitable option for investment.

The Right Mix of Debt and Owners’ Equity

In an ideal situation, there should be a right mix of debt and owners’ equity in financing a firm’s assets. Different types of mixes have different implications. They are as follows −

Debt vs. Equity

Firstly, when we consider debt and equity, there should be an ideal mix of debt versus equity.

Debt is a risky proposition from the owner’s point of view. The firm usually has an obligation to pay the debtors irrespective of the profits and losses made by the firm. When the firm is unable to meet the payments to the debtholders, the debtholders can legally force the company to make the payments. In extreme conditions, the debt holders can force the firm into liquidation if the payments are not made for a long time.

The use of debt is useful for shareholders in mainly two ways. They are as follows −

First, the shareholders can have control of the company with a limited stake.

Second, the shareholders can have increased earnings when the rate of return on total capital employed is more than the interest in the borrowed funds. The process of increasing shareholders’ return using debt is known as Financial Gearing or Financial Leverage.

Debt Increases Risks

Financial leverage can work in opposite direction too. When the cost of debt is higher than the company’s overall rate of return, the earnings from the investment in a firm will be reduced.

There is a threat of insolvency as well. When a firm is liquidated, the worst sufferers from the action are its residual owners–the shareholders. Thus, the use of debt magnifies the return to the owners while also increasing the risks.

Difficulty in Paying Back Debts

Another notable point to consider while mentioning about leverage is that a highly debited firm would always find it difficult to manage additional funds from the investors or from the markets. As the increased burden adds to the difficulty in paying the debt back to the investors, the firms having a very high proportion of debt are considered risky by the investors.

Creditors’ risk is at the highest when the owners’ equity is the thinnest.

Calculation of Leverage Ratio

  • Leverage ratio is calculated to adjudge the condition of a company to derive debt, depending on its financial wellbeing.

  • Leverage ratio is used to determine the financial risks and a firm’s ability to use debt to shareholders’ advantage.

  • Leverage ratios are calculated from the balance sheet items to determine the proportion of debt in the overall financing of the firm.

  • Leverage ratios may also be computed from profit and loss accounts by determining the degree to which the operating profits are enough to encompass the fixed charges.

Conclusion

To conclude, it can be said that there may be more than one type of leverage ratio, but all of them show the overall debt proportion in funding the firm’s assets.

raja
Updated on 15-Apr-2022 12:31:05

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