What Are Financial Leverage Ratios?

Dave Humphreys is an assistant director for the Northwestern Mutual Wealth Management Company.

Before deciding whether or not to invest in a company, it’s important to have an understanding of the company’s financial health. While a lot of investors focus on profitability (and with good reason), that isn’t the only metric to consider (in most cases). The company’s liabilities—how much debt it carries on its balance sheet relative to other financial metrics—is something else to consider.

One way to understand this is by calculating the company’s financial leverage ratios.

Below, you’ll see what financial leverage ratios are and why they’re so important . You’ll also get an understanding of the most common leverage ratios and the different ways you can interpret them to inform your investment strategy.

What is a company’s financial leverage?

Let’s look at the different ways a company can raise money. A company may need money to pursue an expansion, acquire a competitor or simply fund itself during the startup phase. It can do so in one of two ways.

1. It can raise equity capital by selling shares of company stock in exchange for cash, either on the open market or via venture capital and angel investing. Funds raised in this way are called equity capital.

2. The company can also borrow money from a bank or via corporate bonds. Funds raised in this way are called debt capital.

So a company’s financial leverage is a measure of how much debt the company is using to work toward its goals.

What are financial leverage ratios?

Financial leverage ratios are metrics designed to provide context about a company’s debt levels so that investors have a better sense of its overall financial health. Leverage ratios do this by comparing that debt to some other metric, like the company’s equity, assets or earnings.

In general, the lower a company’s financial leverage ratios are, the less it is currently relying on debt to fund its business activities. A leverage ratio looks at comparisons like debt-to-assets, debt-to-equity, debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) and other industry norms.

How financial leverage ratios are calculated

Different ratios used to calculate the financial leverage ratio are based on a company’s finances. For publicly traded companies, most of this information can be found on the company’s balance sheet, which is typically published quarterly. Here is an explanation of some of the ratios used to calculate a leverage ratio:

Debt ratio

The debt ratio compares a company’s debt against its total assets to understand how much of its assets are financed by leverage—and therefore might be at risk in deteriorating market conditions. A debt ratio greater than 1.0 indicates that a company has more debt than assets on its balance sheet.

You can calculate a company’s debt ratio by dividing the company’s total debt by its total assets:

For example, a company that has $50 million worth of assets and $5 million worth of debt would have a debt ratio of 0.1:

Debt Ratio = $5 million / $50 million = 0.1

Debt-to-equity ratio

The debt-to-equity (sometimes referred to as “D/E”) ratio offers a different look at a company’s leverage by comparing its total debt against its total shareholder equity (assets minus liabilities). It helps you understand how much value is being created for shareholders for every dollar of debt, which can help you evaluate the overall risk of investing in a company. High debt-to-equity may indicate that a company is overly reliant on debt.

You can calculate a company’s debt-to-equity ratio by dividing its total debt by its total shareholder equity:

A company with total debt of $200 million and shareholder equity of $80 million would have a D/E ratio of 2.5:

Debt-to-Equity Ratio = $200 million / $80 million = 2.5

Debt-to-EBITDA ratio

The debt-to-EBITDA ratio compares a company’s debt against the amount of cash flow (EBITDA) it generates from business operations. Investors use it to understand how much difficulty a business would have in paying down its debts. High debt-to-EBITDA may indicate that a company will have difficulty meeting its obligations.

You can calculate a company’s debt-to-EBITDA ratio by dividing the company’s total debt by its EBITDA:

A company that generates $2.5 million of EBITDA while carrying $5 million of debt would have a debt-to-EBITDA ratio of 2:

Debt-to-EBITDA Ratio = $5 million / $2.5 million = 2

Other financial leverage ratios

Of course, the ratios discussed above are just a few of the most common financial leverage ratios that investors and lenders tend to consider. Others to be aware of can include a company’s:

• Assets-to-equity ratio, which compares a company’s assets (including debt) against its shareholder equity.

• Debt-to-capital ratio, which compares a company’s debt against its capital base.

• Interest coverage ratio, which compares a company’s interest payments against its operating income.

How to interpret financial leverage ratios

When it comes to interpreting financial leverage ratios, there are some quick rules to keep in mind.

A lower ratio is usually preferable

Debt can be expensive. The more debt a company has, the more of its cash flows must be earmarked for repayment instead of being reinvested in the company or returned to shareholders (for example, in the form of dividends or stock buybacks). So a lower ratio will typically be considered preferable to a higher ratio because it means that a company is less reliant on debt financing. And a high debt burden could spell trouble if market conditions deteriorate, making it difficult for a company to repay its loans.

Financial leverage ratios vary by industry

Certain industries are more capital intensive than other industries, leading to a greater reliance on debt. When comparing the leverage ratios of one company against those of another, it’s a good idea to try and stay within the same industry.

Using financial leverage ratios to make investment decisions

Financial leverage ratios can be a great tool to help you evaluate potential stocks before you make a decision to invest. But it’s important to remember that what’s considered a “good” ratio will depend on several factors, including the industry a company operates within and how mature it is as an enterprise. And remember that financial leverage ratios are just one data point among many that investors can use to judge a potential investment.

Fortunately, many investors don’t need to spend much time on the concept. If you have questions, you can work with a financial advisor to help select investments or funds that are right for you.

Your Northwestern Mutual financial advisor can help you better understand financial leverage ratios—helping you to make the right investment decisions for your situation. By gaining an understanding of what’s important to you, your advisor can help you build a comprehensive financial plan to grow and protect your money—helping you to reach your financial goals.