When you’re looking to expand your business, sometimes you’ll need money from an outside party like a bank or investor. Most lenders and investors will want to look at your debt leverage ratios first before committing any funds. In this guide, we’ll cover:
- What are debt leverage ratios?
- The types of debt leverage ratios you might need to calculate
- What do lenders and investors look for in debt leverage ratios?
A leverage ratio compares a company’s debt with the value of its equity. It’s a gauge of the company’s finances and shows two things:
- How much of the company’s assets are borrowed money
- Whether the company can cover its obligations
Leverage ratios can be calculated from numbers on a company’s income statement, balance sheet and cash flow statement.
This ratio tells the accountants, analysts, investors, lenders and finance managers how a company pays for its assets and operations. Monitoring this ratio will:
- Help predict whether a company can pay off its current debts
- Determine whether you need to scale back debt
- Help you make realistic plans for the future
- Make more strategic decisions regarding your business finances
Three Main Types of Leverage
There are three main types of leverage. These are:
- Financial leverage
- Operating leverage
- Combined leverage
A financial leverage ratio measures how much debt a company uses now or in the future to fund its operations. Operating leverage is measured in fixed costs (a cost that doesn’t change) versus variable costs (a cost that changes). A high figure in this leverage ratio means fixed costs are large compared with revenue. Combined leverage is, as it says on the tin, a mix of financial and operating leverage. Operating income will affect the top of an income statement, while financial leverage the lower part.
Within these, there are five types of leverage ratios you might be asked to calculate.
- Debt-to-assets ratio: company debt divided by total assets
- Debt-to-equity ratio: total debt divided by total shareholders’ equity
- Debt-to-capital ratio: total debt divided by total debt plus total shareholders’ equity
- Debt-to-EBITDA ratio: total debt divided by EBITDA, or earnings before interest, taxes, depreciation and amortization
- Asset-to-equity ratio: divide the total assets by total equity
”Healthy” Debt Leverage Ratio
There’s no single “healthy” debt leverage ratio. What’s “good” for you depends on your industry, business and which ratio you calculate. A general target for the debt to assets ratio would be 0.5 or below. That means no more than half the company is financed by debt. If a debt to assets ratio is around 0.8, it may be a signal there’s too much debt. That ratio might be easier to handle in a capital-intensive business, though. It’s worth looking up typical leverage ratios in your industry, to put your calculations into context. And if there’s something about your numbers that worries you, talk to an accountant for advice.
Sample Calculations
The sample calculations below walk through the math step by step using round numbers. Once you’re familiar with the formulas, you can try them with real figures from your own company.
Say a business has total assets of $30,000. Their debt is $12,000 and total equity is $20,000. Plug those numbers into our debt leverage ratio formulas and you get:
- Total debt divided by total equity: $12,000 / $20,000 = 0.60
- 12/20 = 0.6
- Total debt divided by total assets: $12,000 / $30,000 = 0.4
- 12/30 = 0.4
- Total debt divided by total debt plus total equity: $12,000 / $32,000 = 0.375
- 12/(12+20) = 12/32 = 0.375
A debt to equity ratio of 0.60 suggests this business’s equity supplies the bigger share of its resources.
Here’s a second business’s figures for the period:
- Total assets: $100,000
- Total debt: $35,000
- Total equity: $50,000
- EBITDA: $5,000
Now let’s figure out their ratios for the period.
- Debt to assets ratio formula: $35,000 / $100,000 = 0.35
- 35/100 = 0.35
- Debt to equity ratio formula: $35,000 / $50,000 = 0.70
- 35/50 = 0.7
- Debt to capital ratio formula: $35,000 / $85,000 = 0.412
- 35/85 = 0.412
- Debt to EBITDA ratio: $35,000 / $5,000 = 7.0
- 35/5 = 7
- Asset to equity ratio: $100,000 / $50,000 = 2.0
- 100/50 = 2
This business has a debt to assets ratio of 0.35, meaning less than half its resources are tied up in debts like loans and other liabilities.
About Delancey Street
Delancey Street is a premier, and award winning, business debt settlement company that helps business owners nationwide. Our goal is simple: help you escape debt in a safe and legal manner. Based out of New York, we can help in 49 of 50 states. We tell you how it is; because your business and future is on the line.
