What are the Different Types of Leverage Ratios and How You Can Utilise Them?

Do you want to invest in a company to grow your portfolio? If you feel you have gone through all the numbers and metrics, there’s one metric that you need to pay a little more attention to. It’s leverage ratio. If you are wondering what’s all the big deal about leverage ratios, read on.

What is a Leverage Ratio?

Imagine you want to start a cafe. You have some savings, but not enough to cover everything, including rent, equipment, furniture and that fancy coffee machine. So, you take a loan. Now, your total investment is a mix of your money and borrowed funds. That mix? That’s leverage.

Leverage ratios measure the amount of debt a company incurs to its total assets. They show whether a company is playing it safe or walking a financial tightrope.

Types of Leverage Ratios

The different kinds of leverage ratios include:

• Debt-to-Equity Ratio

A classic ratio, it tells you how much debt a company has compared to equity. The debt-to-equity leverage ratio formula is total debt/ total equity. If the ratio is too high, it means the company is relying heavily on debt, a risky proposition. One economic downturn and it's financial trouble for the company.

For instance, if a company has ₹5 crores in debt and ₹2 crores in equity, the debt-to-equity ratio is 2.5. A high ratio means the company is more dependent on debt.

• Debt Ratio

This ratio looks at debt as a percentage of total assets. It shows how much of a company’s assets are funded by debt. The leverage ratio calculation for debt ratio is total debt divided by total assets. If a company has ₹10 crores in assets and ₹4 crores in debt, the debt ratio is 0.4 (or 40%).

This means 40% of the company’s assets are funded by debt. While a low debt ratio may indicate financial stability, a high debt ratio may reflect higher risk.

• Interest Coverage Ratio

Ever taken a loan and struggled to pay the EMI? This ratio tells us how easily a company can cover its interest expenses. The formula to calculate it is EBIT divided by interest expense. For example, if a company earns ₹5 crores before interest and taxes and has ₹1 crore in interest expenses, the ratio is 5.

If this ratio is high, it means the company is making enough money to pay interest easily. On the other hand, if it’s low, the company might be drowning in interest payments, which is definitely not good news.

• Equity Multiplier

This leverage ratio shows how much of the company’s assets are funded by shareholders’ equity. The leverage ratio formula for equity multiplier is total assets divided by shareholders’ equity. For example, if a company has ₹3 crore in total assets and ₹1 crore in shareholders’ equity, the equity multiplier ratio comes to 3.

A higher ratio is an indication that more assets are funded through debt rather than equity. On the other hand, a lower ratio shows the company relies less on debt financing.

How Can You Utilise Leverage Ratios?

Now that you know the different leverage ratios, how do you use them to make smart investment decisions:

• Understanding Financial Risks

A high leverage ratio can indicate that a company relies heavily on debt, which increases financial risk, especially during economic downturns.

• Comparing Companies Within Industries

Different industries have varying leverage norms. For example, capital-intensive industries typically tend to have higher leverage than tech companies. Comparing a company's leverage ratios with its industry peers can provide insights into whether its debt levels are appropriate.

• Identifying Investment Opportunities

Moderately leveraged companies with strong earnings can provide good investment opportunities. Companies reducing their debt over time may indicate improving financial health and potential stock price appreciation.

Conclusion

Leverage ratios can be an essential tool in your arsenal. Next time you’re considering an investment, go beyond stock prices and revenue and dig into the leverage ratios. They might just save you from a bad investment and who knows, you could possibly spot a hidden gem.