What is a 'Leverage Ratio' Companies rely on a mixture of owners' equity and

debt to finance their operations.

A leverage ratio is any one of several financial measurements that look at how
much capital comes in the form of debt (loans), or assesses the ability of a
company to meet financial obligations.

What is leverage in financial management?

Leverage is the use of various financial instruments or borrowed capital, such as
margin, to increase the potential return of an investment. 2.

The amount of debt used to finance a firm's assets. A firm with significantly more
debt than equity is considered to be highly leveraged.

What is a leveraged income?

Glossary definition: Leveraged Income. ... Income earned through other people's
efforts. There are only 24 hours in a day. Hence, there's only so much you can earn
through your own efforts. But with SFI, you can earn Leveraged Income (in the form
of "override" commissions) when affiliates you've sponsored in SFI make sales

What is the leverage ratio for a bank?

The Tier 1 leverage ratio is the relationship between a banking organization's
core capital and its total assets. The Tier 1 leverage ratio is calculated by
dividing Tier 1 capital by a bank's average total consolidated assets and certain
off-balance sheet exposures

How do you calculate financial leverage ratio?

The key steps involved in the calculation of Financial Leverage are:
1. Compute the total debt owed by the company. ...
2. Estimate the total equity held by the shareholders in the company. ...
3. Divide the total debt by total equity
Excessive leverage by banks is widely believed to have contributed to the global
financial crisis (FSB 2009; FSA 2009). As a result, the G-20 and the Financial
Stability Board have proposed the introduction of a leverage ratio to supplement
risk-based measures of regulatory capital.1 What is leverage? Leverage allows a
financial institution to increase the potential gains or losses on a position or
investment beyond what would be possible through a direct investment of its
own funds.
There are three types of leverage
—balance sheet, economic, and embedded—and no single measure can capture
all three dimensions simultaneously.
The first definition is based on balance sheet concepts,
the second on market-dependent future cash flows
, and the third on market risk.
Balance sheet leverage is the most visible and widely recognized form.
Whenever an entity’s assets exceed its equity base, its balance sheet is said to be
leveraged. Banks typically engage in leverage by borrowing to acquire more
assets, with the aim of increasing their return on equity. Banks face economic
leverage when they are exposed to a change in the value of a position by more
than the amount they paid for it. A typical example is a loan guarantee that does
not show up on the bank’s balance sheet even though it involves a contingent
commitment that may materialize in the future. Embedded leverage refers to a
position with an exposure larger than the underlying market factor, such as
when an institution holds a security or exposure that is itself leveraged. A
simple example is a minority investment held by a bank in an equity fund that is
itself funded by loans. Embedded leverage is extremely difficult to measure,
whether in an individual institution or in the financial system. Most structured
Excessive leverage by banks is widely believed to have contributed to the global
financial crisis. To address this, the international community has proposed the
adoption of a non-risk-based capital measure, the leverage ratio, as an additional
prudential tool to complement minimum capital adequacy requirements. Its
adoption can reduce the risk of excessive leverage building up in individual
entities and in the financial system as a whole. The leverage ratio has inherent
limitations, however, and should therefore be considered as just one of a set of
macro- and micro-prudential policy tools. The Leverage Ratio Katia
D’HulsterA New Binding Limit on Banks Katia D’Hulster
(kdhulster@worldbank .org) is a senior financial sector specialist in the
Financial Systems Department of the World Bank. This is the 11th in a series of
policy briefs on the crisis—assessing the policy responses, shedding light on
financial reforms currently under debate, and providing insights for emerging-
market policy makers. THE WORLD BANK GROUP FINANCIAL AND
PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY DECEMBER
2009 NOTE NUMBER 11 credit products have high levels of embedded
leverage, resulting in an overall exposure to loss that is a multiple of a direct
investment in the underlying portfolio. Two-layer securitizations or
resecuritizations, such as in the case of a collateralized debt obligation that
invests in asset-backed securities, can boost embedded leverage to even higher
levels.2 Measures of leverage The most widely used measure of leverage for
regulatory purposes is the leverage ratio. Leverage can also be expressed as a
leverage multiple, which is simply the inverse of the leverage ratio. The
leverage ratio is generally expressed as Tier 1 capital as a proportion of total
adjusted assets. Tier 1 capital is broadly defined as the sum of capital and
reserves minus some intangible assets such as goodwill, software expenses, and
deferred tax assets.3 In calculating the leverage ratio, these intangibles have to
be removed from the total asset base as well, to make it comparable to Tier 1
capital (figure 1). The leverage ratio can thus be thought of as a measure of
balance sheet or, to the extent that it also includes off-balance-sheet exposures
(Breuer 2000), economic leverage. As a result of differences in accounting
regimes, balance sheet presentation, and domestic regulatory adjustments,
however, the measurement of leverage ratios varies across jurisdictions and
banks. Accounting regimes lead to the largest variations. In particular, the use
of International Financial Reporting Standards results in significantly higher
total asset amounts, and therefore lower leverage ratios for similar exposures,
than does the use of U.S. generally accepted accounting principles. The reason
is that under International Financial Reporting Standards netting conditions are
much stricter and the gross replacement value of derivatives is therefore
generally shown on the balance sheet, even when positions are held under
master netting agreements with the same counterparty. As with regulatory
capital measures, the leverage ratio generally applies at the level of the
individual bank as well as on a consolidated basis. How the ratio is actually
calculated and monitored will therefore usually be aligned with the scope of
prudential consolidation practiced in a jurisdiction. Who uses a leverage ratio?
Three countries with large international banking systems are either using a
leverage ratio or have announced plans to do so. The United States and Canada
have maintained a leverage ratio alongside risk-based capital adequacy
requirements, while Switzerland has announced the introduction of a leverage
ratio that will become effective in 2013. Other countries will probably also
adopt this tool. These countries may use a leverage ratio for both micro- and
macro-prudential purposes—for example, as a maximum leverage limit for
supervised entities, an indicator for monitoring vulnerability, or a trigger for
increased surveillance or capital requirements under Pillar 2 of the Basel II
capital accord. Among the three countries, the United States has the simplest
leverage ratio, expressed as a minimum ratio of Tier 1 capital to total average
adjusted assets (defined as the quarterly average total assets less deductions that
include goodwill, investments deducted from Tier 1 capital, and deferred taxes).
The leverage ratio is set at 3 percent for banks rated “strong” (those that present
no supervisory, operational, and managerial weaknesses and are therefore rated
highly under the supervisory rating system) and at 4 percent for all other banks.
Banks’ actual leverage ratios are typically higher than the minimum, however,
because banks are also subject to prompt corrective action rules requiring them
to maintain a minimum leverage ratio of 5 percent in order to be considered
well capitalized. The U.S. leverage ratio applies on a consolidated basis (at the
level of the bank holding company) as well as at the level of individual banks,
but it does not take into account off-balance-sheet exposures. A higher ratio
may be required for any institution if warranted by its risk profile or
circumstances. The larger U.S. investment bank holding companies and their
subsidiaries were regulated by the Securities and Exchange Commission and
thus were not subject to a leverage limit.4 Instead, there were restrictions at the
level of the individual firm 2 THE LEVERAGE RATIO A NEW BINDING
LIMIT ON BANKS Figure How the leverage ratio is calculated 1 Note:
Intangible assets include goodwill, software expenses, and deferred tax assets.
Equity Reserves Intangible assets

Tier 1 capital Total assets Intangible assets

Adjusted assets Tier 1 capital/Adjusted assets

Leverage ratio age ratio, with an expansive definition of assets and a

conservative definition of capital, as a supplementary binding measure to the
Basel II risk-based framework (BCBS 2009). Benefits of the leverage ratio
Introducing the leverage ratio as an additional prudential tool has several
potential benefits. A countercyclical measure The financial crisis has illustrated
the disruptive effects of procyclicality (amplification of the effects of the
business cycle) and of the risk that can build up when financial firms acting in
an individually prudent manner collectively create systemic problems. There is
now broad consensus that micro-prudential regulation needs to be
complemented by macro-prudential regulation that smooths the effects of the
credit cycle (FSA 2009; Andritzky and others 2009). This has led to proposals
for countercyclical capital requirements and loan loss provisions that would be
higher in good times and lower in bad times. The leverage ratio is versatile
enough to be used both as a macro- or micro-prudential policy tool and as a
countercyclical instrument. Intuitively, one would expect that in a fair-value
environment a rise in asset prices would boost bank equity or net worth as a
percentage of total assets. Stronger balance sheets would result in a lower
leverage multiple. Conversely, in a downturn, asset prices and the net worth of
the institution would fall and the leverage multiple would be likely to increase
(table 1). Contrary to intuition, however, empirical evidence has shown that
bank leverage rises during boom times and falls during downturns. Leverage is
said to be procyclical because the expansion and contraction of balance sheets
amplify rather than counteract the credit cycle. The reason is that banks actively
manage their leverage during the cycle using collateralized borrowing and
lending. When monetary policy is “loose” relative to macroeconomic
fundamentals, banks expand their balance sheets and, as a consequence, the
supply of liquidity increases. In contrast, when monetary policy is “tight,” banks
contract their balance sheets, reducing the overall supply of liquidity (see
Adrian and Shin 2008). To reduce procyclicality, banking supervisors can limit
the buildup of leverage in an upturn by setting a floor on the leverage ratio or a
ceiling on the amount of customer receivables the investment bank could hold
as a multiple of capital (net capital rule). Only two of the five investment bank
holding companies originally affected by this rule still exist (Goldman Sachs
and Morgan Stanley), however, and they have now been converted into bank
holding companies. The Canadian “assets to capital multiple” is a more
comprehensive leverage ratio because it also measures economic leverage to
some extent. It is applied at the level of the consolidated banking group by
dividing an institution’s total adjusted consolidated assets—including some off-
balancesheet items5 —by its consolidated (Tier 1 and 2) capital. Under this
requirement total adjusted assets should be no greater than 20 times capital,
although a lower multiple can be imposed for individual banks by the Canadian
supervisory agency, the Office of the Superintendent of Financial Institutions
(OSFI). This is more conservative than the U.S. leverage ratio—and the
inclusion of off-balance-sheet items strengthens the ratio even more. Indeed, the
stringency of Canada’s leverage ratio has been cited as one factor—along with
sound supervision and regulation, good cooperation between regulatory
agencies, strict capital requirements, and conservative lending practices—
contributing to the strong performance of its financial sector during the financial
crisis (IMF 2009). In 2008 the Swiss regulator FINMA, in strengthening capital
adequacy requirements, introduced a minimum leverage ratio under Pillar 2 of
Basel II solely for Credit Suisse and UBS. The Swiss leverage ratio is based on
Tier 1 capital as a proportion of total adjusted assets and is set at a minimum of
3 percent at the consolidated level and 4 percent at the individual bank level.
For the calculation of this new benchmark, the balance sheet under International
Financial Reporting Standards is adjusted for a number of factors, the most
noteworthy being the deduction of the entire domestic loan book (the Swiss
authorities presumably wanted to ensure that introducing the leverage ratio
would not hamper expansion of the domestic credit market). Other adjustments
are more common, such as exclusion of the replacement values of derivatives to
reduce the effects of the strict netting rules under International Financial
Reporting Standards. The Basel Committee on Banking Supervision has
recently proposed the introduction of a lever- 4 on the leverage multiple. The
leverage ratio limit could also be expressed as a range with a long-term target
level. Alternatively, there could be a mechanism to relax the limit during
downturns, since constant fixed caps on the leverage ratio (or constant fixed
floors on the leverage multiple) could amplify procyclicality by encouraging
banks to deleverage during a downturn (and vice versa). Less regulatory
arbitrage The greater risk sensitivity of Basel II capital requirements can result
in a perverse incentive for financial institutions to structure products so that they
qualify for lower capital requirements. When this incentive is collectively
exploited, the system is likely to end up with high concentrations of structured
exposures subject to low regulatory capital requirements. A minimum leverage
ratio, among other measures, can help dampen this perverse incentive by acting
as a backstop to risk-based capital requirements (Hildebrand 2008). Moreover,
it can be customized to individual banks’ risk profiles. Simplicity The leverage
ratio is simple to apply and monitor. As a result, it can be adopted quickly and
without leading to high costs or requirements for expertise for banks or their
supervisors. Moreover, the leverage ratio can be applied regardless of the
capital adequacy regime in a jurisdiction. Limitations of the leverage ratio
While the leverage ratio offers benefits, it is also subject to several weaknesses
that policy makers need to take into account. Wrong incentives The leverage
ratio does not distinguish different types of bank assets by their riskiness and, in
the absence of risk-based capital requirements such as those under Basel I or II,
may thus encourage banks to build up relatively riskier balance sheets or expand
their off-balance-sheet activity. Moreover, because of the crude calculation of
the leverage ratio, prudent banks holding substantial portfolios of highly liquid,
high-quality securities may argue that they are being punished for their
conservatism. Limited to balance sheet leverage One argument against the
leverage ratio has been that the United States, despite having a leverage ratio in
place, was at the epicenter of the global financial crisis. Why did the U.S.
leverage ratio fail to provide the right warning signs? To answer this question, a
good starting point is to analyze the evolution of leverage in the years running
up to the financial crisis. Over the past decades financial innovation has
fundamentally changed the structure of the financial system. This trend is
exemplified by credit risk transfer instruments such as structured credit
products, through which portfolios of credit exposures can be sliced and
repackaged to meet the needs of investors. Banks funded a growing amount of
long-term assets with short-term liabilities in wholesale markets through the use
of off-balance-sheet vehicles, exposing themselves to credit and liquidity risk
by providing facilities to these vehicles. Moreover, they also held structured
credit instruments on their own balance sheet, exposing themselves to
embedded leverage and increasing their asset-liability mismatch and their
funding liquidity risk. For major European and U.S. investment banks, balance
sheet leverage multiples (measured as total assets divided by equity) increased
during the four years preceding the global financial crisis (figure 2). For
Japanese and U.S. comTable Hypothetical movements of a leverage multiple or
ratio in a fair-value environment 1 Leverage multiple Leverage ratio (%)
Starting point Adjusted assets: 100 Tier 1: 4 25 4 Upturn in credit cycle
Adjusted assets: 100 3
103 Tier 1: 4 3

7 14.7 6.8 Downturn in credit cycle Adjusted assets: 100 2

98 Tier 1: 4 2

2 49 2.04 mercial banks, by contrast, aggregate balance sheet leverage did not
increase over this period, and in some instances it even fell. As can be deduced,
the balance sheet leverage ratio did not adequately reflect the trends in financial
innovation because significant leverage was assumed through economic and
embedded leverage, which is not recorded on the balance sheet. In addition,
factors not captured by the leverage ratio or by risk-based capital requirements
also contributed to the crisis, such as weak underwriting standards for
securitized assets and the buildup of such risks as funding liquidity risk. As a
result, the extent of leverage accumulated in the financial system in recent years
has only recently become visible. Conclusion There appears to be consensus
that no single tool or measure would have prevented the financial crisis and that
an adequate policy response requires a menu of macro- and micro-prudential
policy tools. The leverage ratio can be a useful prudential tool, and one that can
be relatively easy to implement, for jurisdictions that do not want to rely solely
on risk-sensitive capital requirements—though it is no silver bullet. Combining
the leverage ratio with Basel-type capital rules can reduce the risk of excessive
leverage building up in individual entities and in the system as a whole. As the
financial crisis showed, however, policy makers need to be cognizant of the
inherent limitations and weaknesses of the leverage ratio. The proposals at an
international level to supplement risk-based measures with an internationally
harmonized and appropriately calibrated leverage ratio are welcome and could
lead to its adoption by a wide range of countries in the future. A leverage ratio
cannot do the job alone; it needs to be complemented by other prudential tools
or measures to ensure a comprehensive picture of the buildup of leverage in
individual banks or banking groups as well as in the financial system.
Additional measures to provide a comprehensive view of aggregate leverage,
including embedded leverage, and to trigger enhanced surveillance by
supervisors need to be developed. Notes The author would like to thank
DamodaranKrishnamurti for his input on an earlier version and Constantinos
Stephanou, Joon Soo Lee, Cedric Mousset, Tom Boemio, and David Scott for
their valuable comments and suggestions. 1. For example, the G-20 Declaration
of April 2009 on Strengthening the Financial System states that “riskbased
capital requirements should be supplemented with a simple, transparent, non-
risk based measure which is internationally comparable, properly takes

Financial leverage ratios, sometimes called equity or debt ratios, measure the
value of equity in a company by analyzing its overall debt picture. These ratios
either compare debt or equity to assets as well as shares outstanding to measure
the true value of the equity in a business.

In other words, the financial leverage ratios measure the overall debt load of a
company and compare it with the assets or equity. This shows how much of the
company assets belong to the shareholders rather than creditors. When
shareholders own a majority of the assets, the company is said to be less
leveraged. When creditors own a majority of the assets, the company is
considered highly leveraged. All of these measurements are important for
investors to understand how risky the capital structure of a company and if it is
worth investing in.

Here are the most common financial leverage ratios

Debt ratio is a solvency ratio that measures a firm's total liabilities as a

percentage of its total assets. In a sense, the debt ratio shows a company's ability
to pay off its liabilities with its assets. In other words, this shows how many
assets the company must sell in order to pay off all of its liabilities.
This ratio measures the financial leverage of a company. Companies with higher
levels of liabilities compared with assets are considered highly leveraged and
more risky for lenders.
This helps investors and creditors analysis the overall debt burden on the
company as well as the firm's ability to pay off the debt in future, uncertain
economic times.

Formula
The debt ratio is calculated by dividing total liabilities by total assets. Both of
these numbers can easily be found the balance sheet. Here is the calculation:

Make sure you use the total liabilities and the total assets in your calculation.
The debt ratio shows the overall debt burden of the company—not just the
current debt.

The equity ratio is an investment leverage or solvency ratio that measures the
amount of assets that are financed by owners' investments by comparing the
total equity in the company to the total assets.
The equity ratio highlights two important financial concepts of a solvent and
sustainable business. The first component shows how much of the total
company assets are owned outright by the investors. In other words, after all of
the liabilities are paid off, the investors will end up with the remaining assets.

The second component inversely shows how leveraged the company is with
debt. The equity ratio measures how much of a firm's assets were financed by
investors. In other words, this is the investors' stake in the company. This is
what they are on the hook for. The inverse of this calculation shows the amount
of assets that were financed by debt. Companies with higher equity ratios show
new investors and creditors that investors believe in the company and are
willing to finance it with their investments.

Formula

The equity ratio is calculated by dividing total equity by total assets. Both of
these numbers truly include all of the accounts in that category. In other words,
all of the assets and equity reported on the balance sheet are included in the
equity ratio calculation.
TYPES OF LEVERAGE
There is a different basis for classifying business expenses. For our convenience, let us classify
fixed expenses into operating fixed expenses such as depreciation on fixed expenses, salaries
etc, and financial fixed expenses such as interest and dividend on preference shares. Similar to
them, leverages are also of two types – financial leverage and operating leverage.
FINANCIAL LEVERAGE

Financial leverage is a leverage created with the help of debt component in the capital structure
of a company. Higher the debt, higher would be the financial leverage because with higher debt
comes the higher amount of interest that needs to be paid.

Leverage can be both good and bad for a

business depending on the situation. If a firm is able to generate a higher return on investment
(ROI) than the interest rate it is paying, leverage will have its positive effect shareholder’s return.
The darker side is that if the said situation is opposite, higher leverage can take a business to a
worst situation like bankruptcy.
OPERATING LEVERAGE

Operating leverage, just like the financial leverage, is a result of operating fixed expenses. Higher
the fixed expense, higher is the operating leverage. Like the financial leverage had an impact on
the shareholder’s return or say earnings per share, operating leverage directly impacts the operating
profits (Profits before Interest and Taxes (PBIT)). Under good economic conditions, due
to operating leverage, an increase of 1% in sales will have more than 1% change in operating
profits.
So, you need to be very careful in adding any of the leverages to your business viz. financial
leverage or operating leverage as it can also work as a double edged sword.

ADVANTAGES AND DISADVANTAGES OF LEVERAGE

In totality, it has its advantages under good economic situations and at the same time, it is not
free from disadvantages.

ADVANTAGES OF HIGHER LEVERAGE

Take operating leverage, the operating profits can see a sharp increase with a small change in
sales as most parts of the expenses are stagnant and cannot further increase with sales.

Likewise, if we consider financial leverage, the earnings share of each shareholder will increase
significantly with an increase in operating profits. Here, higher the degree of leverage, higher will be the
percentage increase in operating profits and earnings per share.
DISADVANTAGES OF HIGHER LEVERAGE

Leverage inherits the risk of bankruptcy along with it. In the case of operating leverage, fixed
expenses extend the break-even point for a business. Breakeven

means the minimum activity (sales) required for achieving no loss / no profit situation. Financial
leverage increases the minimum requirement of operating profits to meet with the expense of
interest. In any case, if the required activity level not achieved, bankruptcy or cash losses
become certain.
Looking at the pros and cons of leverage, it seems that a balance is required between the
rewards and risks associated with leverage. The degree of leverage should not be too high which
invites the bankruptcy and on the contrary, it should not be too low that we lose out on the
benefits and the viability of a business itself comes under question.