As we wrap up our festival of metrics, we’re shining the spotlight on leverage ratios.
These ratios allow you to determine your company’s financial risk. Most lenders will use leverage ratios to assess the potential risk of a company before deciding to lend to them.
Why leverage ratios matter
Most companies rely on both equity and debt to finance operations. Leverage ratios provide a view of the level of debt a business is carrying. They answer the all-important question, “Does the organization have the ability to service and repay the debt?”
Lenders often use leverage ratios to help them assess an organization’s funding risk. As ratios improve or deteriorate, it can directly affect the interest rates an organization will be charged.
A higher and increasing leverage ratio may mean that your business is using more debt to finance assets and operations — which could indicate that it’s on shaky financial footing. Conversely, a lower ratio typically shows a company with low financial risk and less risk to lenders and investors.
These ratios are also an important metric for shareholders and management. Because debt borrowing can improve shareholder returns, shareholders may be pleased to learn your organization is operating with a reasonable level of leverage.
Management, of course, can use its understanding of leverage ratios to make critical decisions about the amount of debt the company is carrying and whether any adjustments need to be made to lower risk or increase debt to grow or make new investments.
Common leverage ratios
As with the other metrics we’ve explored during the festival of metrics, the various leverage ratios available can offer different insights depending on what you’re looking to measure.
These are the most commonly used leverage ratios:
- Debt ratio: Calculated as total borrowings divided by total assets. Measures the percent of assets that are being financed with borrowings.
- Debt to equity ratio: Calculated as total borrowings divided by shareholder equity. Measures the weight of borrowings against shareholder equity.
- Interest cover ratio: Calculated as EBIT (Earnings Before Interest and Tax) divided by interest. Measures how many times the company can cover interest expense out of earnings.
- Debt to EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) ratio: Calculated as debt divided by EBITDA. Measures the amount of earnings that is available to payback debt before paying interest and tax.
How to use these ratios for maximum value
Understanding leverage ratios provides critical insights into the financial health of your business. Although it can be useful to calculate these ratios on their own, they can deliver much more meaningful insights when tracked and studied over time.
You can line these metrics up side by side and select a monthly view to observe the trends over time. Additionally, you can compare a data set to another period of your choosing (e.g., November 2020 vs. November 2021). As your numbers shift in real-time, the data in the financial statement updates automatically — unlike in static reporting, where you’d have to make the changes by hand.
Knowing your company’s leverage ratio helps you determine how much debt your company is carrying and how much wiggle room you have — in other words, how much debt you can continue to take on and still meet the terms of your financial covenants.
To learn more about how Phocas’s financial solutions can maximize the value of your company's financial ratios, download this ebook: Modern Financial Planning and Reporting.