Any of the various metrics used to evaluate a company's solvency that factor in the proportion of its total capital in the form of debt is known as a leverage ratio. Since most businesses utilize a combination of equity and debt to fund their operations, the leverage ratio category is crucial for determining whether or not the firm can meet its financial obligations as they come due. Several typical leverage ratios will be covered in this article.
A Leverage Ratio: What Does It Reveal?
A corporation and its investors should be wary of too much debt. On the other hand, debt may be helpful for expansion if the return on investment from the company's activities is higher than the interest rate on its loans. Credit downgrades or even bankruptcy might result from out-of-control debt.
However, concerns might also be raised if there are too few debts. Any hesitation or difficulty in getting credit should raise red flags about the health of the company's profit margins. Multiple ratios can be defined as leverage ratios, but debt, equity, assets, and interest payments are the most important ones to examine.
You can get an idea of how changes in output will affect operating income by looking at the leverage ratio of a company, which measures the mix of operating expenses. There are two categories of operational fees, fixed and variable costs, with the exact breakdown varying by firm and market.
Financial Institutions and Debt-to-Equity Ratios
Many American businesses and organizations, including banks, use a lot of debt as a means of financing. As a result of FDIC insurance and fractional reserve banking, banks can now provide more risk-free loans to customers. As a result, the FDIC, the Federal Reserve, and the Comptroller of the Currency all keep an eye on and limit American banks' leverage ratios.
The amount of money a bank may give out is thus constrained by the amount it must keep in its assets. When asset values fall, banks can "write down" the capital part of their assets to compensate for the loss. Since the bank still owes money to its bondholders and depositors, it cannot write down the value of the assets helping to service that obligation.
Leverage Ratios for Assessing Financial Stability and Capital Structure
The debt-to-equity ratio is probably the best-known measure of financial leverage.
Calculating the Ratio of Debt to Equity
The level of debt about the total value of the company's equity is called its debt-to-capital ratio. Because it isolates debt liabilities as a percentage of total capital, it is one of the most insightful debt ratios. Both current and future debts are counted together. Together, debt and equity make up a company's capital.
This ratio is applied to assess a company's financial structure and operational financing methods. Due to the constraints that debt places on a business, a high debt-to-capital ratio often indicates an increased risk of default. The debt-to-capital balance in the oil business appears to be around 40 percent—costs associated with carrying debt rise sharply over that threshold.
Debt-to-EBITDA Ratio
When analyzing a company's solvency, the debt-to-EBITDA leverage ratio is used. Credit bureaus commonly use this ratio to estimate the likelihood of defaulting on given debt. This ratio helps estimate how many years of EBITDA would be needed to repay all indebtedness for oil and gas firms, which often have a lot of debt on their balance sheets. While a ratio greater than three may signal trouble in some sectors, this threshold may shift from one business sector to another.
Debt-to-EBITDAX
Debt-to-EBITDAX ratios are identical to the standard debt-to-EBITDA ratio, with the exception that EBITDAX includes exploration expenses only for enterprises that are successful in their endeavors. This ratio is frequently used in the US to standardize alternative accounting methods for exploration costs.
Costs associated with exploration are recorded in the books as exploration, abandonment, and dry-hole expenses. Impairments, accretion of asset retirement liabilities, and deferred taxes are other noncash expenditures that need to be recalculated.
Interest Coverage Ratio
The interest coverage ratio is yet another leverage ratio that considers interest expenses. Looking merely at a firm's overall debt liabilities might be misleading because they don't indicate whether or not the company can afford to make its debt payments. The Interest Coverage Ratio was created to address this very problem.
This ratio, calculated by dividing operational revenue by interest expenditures, demonstrates the firm's capacity to meet its interest obligations. Even though it varies from industry to industry, a ratio of 3.0 or greater is generally considered to be optimal.
