what does a leverage ratio tell you 
in most cases leverage ratios assess the ability of a company to meet its financial obligations too much debt can be dangerous for a company and its investors however if a company s operations can generate a higher rate of return than the interest rate on its loans then the debt may help to fuel growth uncontrolled debt levels can lead to credit downgrades or worse on the other hand too few debts can also raise questions a reluctance or inability to borrow may indicate that operating margins are tight several different ratios may be categorized as leverage ratios the main factors considered are debt equity assets and interest expenses a leverage ratio may also be used to measure a company s mix of operating expenses to get an idea of how changes in output will affect operating income fixed and variable costs are the two types of operating costs depending on the company and the industry the mix will differ another leverage ratio is the consumer leverage ratio this ratio looks at the level of consumer debt compared to disposable income and is used in economic analysis and by policymakers understanding how debt amplifies returns is the key to understanding leverage debt is not necessarily a bad thing particularly if the debt is taken on to invest in projects that will generate positive returns leverage can thus multiply returns although it can also magnify losses if returns turn out to be negative banks and leverage ratiosbanks are among the most leveraged institutions in the united states the combination of fractional reserve banking and federal deposit insurance corp fdic protection has produced a banking environment with limited lending risks to compensate for this three separate regulatory bodies the fdic the federal reserve and the comptroller of the currency review and restrict the leverage ratios for american banks 1 these bodies restrict how much money a bank can lend relative to how much capital the bank devotes to its own assets the level of capital is important because banks can write down the capital portion of their assets if total asset values drop assets financed by debt cannot be written down because the bank s bondholders and depositors are owed those funds banking regulations for leverage ratios are complicated the federal reserve created guidelines for bank holding companies although these restrictions vary depending on the rating assigned to the bank in general banks that experience rapid growth or face operational or financial difficulties are required to maintain higher leverage ratios 2there are several forms of capital requirements and minimum reserve placed on american banks through the fdic and the comptroller of the currency that indirectly impact leverage ratios the level of scrutiny paid to leverage ratios has increased since the great recession of 2007 to 2009 when banks that were too big to fail were a calling card to make banks more solvent and these pressures haven t gone away restrictions keep getting tighter 3in 2023 following the collapse of several lenders regulators proposed that banks with 100 billion or more in assets dramatically add to their capital cushions these restrictions naturally limit the number of loans made because it is more difficult and more expensive for a bank to raise capital than it is to borrow funds higher capital requirements can reduce dividends or dilute share value if more shares are issued 4for banks the tier 1 leverage ratio is most commonly used by regulators 56types of leverage ratiosthere are many different leverage ratios below we look at some of the more common ones perhaps the most well known financial leverage ratio is the debt to equity d e ratio this is expressed as debt to equity ratio total liabilities total shareholders equity text debt to equity ratio frac text total liabilities text total shareholders equity debt to equity ratio total shareholders equitytotal liabilities for example in the quarter ending june 30 2023 united parcel service s long term debt was 19 35 billion and its total stockholders equity was 20 0 billion the company s d e for the quarter was 0 97 7a high debt equity ratio generally indicates that a company has been aggressive in financing its growth with debt this can result in volatile earnings as a result of the additional interest expense if the company s interest expense grows too high it may increase the company s chances of default or bankruptcy typically a d e ratio greater than 2 0 indicates a risky scenario for an investor however this yardstick can vary by industry businesses that require large capital expenditures capex such as utility and manufacturing companies may need to secure more loans than other companies it s a good idea to measure a firm s leverage ratios against past performance and with companies operating in the same industry in order to better understand the data the equity multiplier is similar but replaces debt with assets in the numerator equity multiplier total assets total equity text equity multiplier frac text total assets text total equity equity multiplier total equitytotal assets for example assume that macy s has assets valued at 19 85 billion and stockholder equity of 4 32 billion the equity multiplier would be 19 85 billion 4 32 billion 4 59 19 85 text billion div 4 32 text billion 4 59 19 85 billion 4 32 billion 4 59although debt is not specifically referenced in the formula it is an underlying factor given that total assets include debt remember that total assets total debt total shareholders equity the company s high ratio of 4 59 means that assets are mostly funded with debt rather than equity from the equity multiplier calculation macy s assets are financed with 15 53 billion in liabilities the equity multiplier is a component of the dupont analysis for calculating return on equity roe dupont analysis n p m a t e m where n p m net profit margin a t asset turnover e m equity multiplier begin aligned text dupont analysis npm times at times em textbf where npm text net profit margin at text asset turnover em text equity multiplier end aligned dupont analysis npm at emwhere npm net profit marginat asset turnoverem equity multiplier generally it is better to have a low equity multiplier as this means a company is not incurring excessive debt to finance its assets the debt to capitalization ratio measures the amount of debt in a company s capital structure it is calculated as total debt to capitalization s d l d s d l d s e where s d short term debt l d long term debt s e shareholders equity begin aligned text total debt to capitalization frac sd ld sd ld se textbf where sd text short term debt ld text long term debt se text shareholders equity end aligned total debt to capitalization sd ld se sd ld where sd short term debtld long term debtse shareholders equity in this ratio operating leases are capitalized and equity includes both common and preferred shares instead of using long term debt an analyst may decide to use total debt to measure the debt used in a firm s capital structure in this case the formula would include minority interest and preferred shares in the denominator degree of financial leverage dfl is a ratio that measures the sensitivity of a company s earnings per share eps to fluctuations in its operating income as a result of changes in its capital structure it measures the percentage change in eps for a unit change in earnings before interest and taxes ebit and is represented as d f l change in e p s change in e b i t where e p s earnings per share e b i t earnings before interest and taxes begin aligned dfl frac text change in eps text change in ebit textbf where eps text earnings per share ebit text earnings before interest and taxes end aligned dfl change in ebit change in eps where eps earnings per shareebit earnings before interest and taxes dfl can alternatively be represented by the equation below d f l e b i t e b i t interest dfl frac ebit ebit text interest dfl ebit interestebit this ratio indicates that the higher the degree of financial leverage the more volatile earnings will be since interest is usually a fixed expense leverage magnifies returns and eps this is good when operating income is rising but it can be a problem when operating income is under pressure the consumer leverage ratio is used to quantify the amount of debt that the average american consumer has relative to their disposable income some economists have stated that the rapid increase in consumer debt levels has been a contributing factor to corporate earnings growth over the past few decades others blamed the high level of consumer debt as a major cause of the great recession consumer leverage ratio total household debt disposable personal income text consumer leverage ratio frac text total household debt text disposable personal income consumer leverage ratio disposable personal incometotal household debt the debt to capital ratio is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a company s total capital base it is calculated by dividing a company s total debt by its total capital which is total debt plus total shareholders equity debt includes all short term and long term obligations this ratio is used to evaluate a firm s financial structure and how it is financing operations generally the higher the debt to capital ratio the higher the risk of default if the ratio is very high earnings may not be enough to cover the cost of debts and liabilities again what constitutes a reasonable debt to capital ratio depends on the industry some sectors use more leverage than others the debt to ebitda leverage ratio measures the amount of income generated and available to pay down debt before a company accounts for interest taxes depreciation and amortization expenses this ratio which is commonly used by credit agencies and is calculated by dividing short and long term debt by ebitda determines the probability of defaulting on issued debt this ratio is useful in determining how many years of earnings before interest taxes depreciation and amortization ebitda would be required to pay back all the debt typically it can be alarming if the ratio is over 3 but this can vary depending on the industry the debt to ebitdax ratio is similar to the debt to ebitda ratio it just measures debt against ebitdax rather than ebitda ebitdax stands for earnings before interest taxes depreciation or depletion amortization and exploration expense it expands ebitda by excluding exploration costs a common expense for oil and gas companies this ratio is commonly used in the united states to normalize different accounting treatments for exploration expenses the full cost method vs the successful efforts method exploration costs are typically found in financial statements as exploration abandonment and dry hole costs other non cash expenses that should be added back in are impairments accretion of asset retirement obligations and deferred taxes another leverage ratio concerned with interest payments is the interest coverage ratio one problem with only reviewing the total debt liabilities for a company is that they do not tell you anything about the company s ability to service the debt this is exactly what the interest coverage ratio aims to fix this ratio which equals operating income divided by interest expenses showcases the company s ability to make interest payments generally a ratio of 3 0 or higher is desirable although this varies from industry to industry times interest earned tie also known as a fixed charge coverage ratio is a variation of the interest coverage ratio this leverage ratio attempts to highlight cash flow relative to interest owed on long term liabilities to calculate this ratio find the company s earnings before interest and taxes ebit then divide by the interest expense of long term debts use pretax earnings because interest is tax deductible the full amount of earnings can eventually be used to pay interest again higher numbers are more favorable 