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    Leverage Ratio

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    Sundeep kumar
    A leverage ratio measures the amount of debt a company uses to finance its assets and operations. It is an important metric for evaluating a company's solvency and risk level. Some common leverage ratios include the debt-to-equity ratio, which compares total debt to shareholders' equity, and the equity multiplier, which compares total assets to shareholders' equity. A high leverage ratio means a company is more sensitive to changes in revenues and profits and takes on greater risk. Leverage ratios are used to analyze both businesses and consumers' use of debt.

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    Leverage Ratio

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    Sundeep kumar
    46 views3 pages
    A leverage ratio measures the amount of debt a company uses to finance its assets and operations. It is an important metric for evaluating a company's solvency and risk level. Some common leverage ratios include the debt-to-equity ratio, which compares total debt to shareholders' equity, and the equity multiplier, which compares total assets to shareholders' equity. A high leverage ratio means a company is more sensitive to changes in revenues and profits and takes on greater risk. Leverage ratios are used to analyze both businesses and consumers' use of debt.

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    investopedia.com-Leverage Ratio

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    A leverage ratio measures the amount of debt a company uses to finance its assets and operations. It is an important metric for evaluating a company's solvency and risk level. Some common leverage ratios include the debt-to-equity ratio, which compares total debt to shareholders' equity, and the equity multiplier, which compares total assets to shareholders' equity. A high leverage ratio means a company is more sensitive to changes in revenues and profits and takes on greater risk. Leverage ratios are used to analyze both businesses and consumers' use of debt.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
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    46 views3 pages

    Leverage Ratio

    Uploaded by

    Sundeep kumar
    A leverage ratio measures the amount of debt a company uses to finance its assets and operations. It is an important metric for evaluating a company's solvency and risk level. Some common leverage ratios include the debt-to-equity ratio, which compares total debt to shareholders' equity, and the equity multiplier, which compares total assets to shareholders' equity. A high leverage ratio means a company is more sensitive to changes in revenues and profits and takes on greater risk. Leverage ratios are used to analyze both businesses and consumers' use of debt.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
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    Leverage Ratio

    investopedia.com/terms/l/leverageratio.asp

    What is a Leverage Ratio


    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 its
    financial obligations. The leverage ratio is important given that companies rely on a mixture
    of equity and debt to finance their operations, and knowing the amount of debt held by a
    company is useful in evaluating whether it can pay its debts off as they come due.

    BREAKING DOWN Leverage Ratio


    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 is helping to fuel growth in profits. Nonetheless, uncontrolled debt
    levels can lead to credit downgrades or worse. On the other hand, too few debt can also
    raise questions. A reluctance or inability to borrow may be a sign that operating margins
    are simply too tight.

    There are several different specific ratios that may be categorized as a leverage ratio, but
    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.

    Finally, the consumer leverage ratio refers to the level of consumer debt as compared to
    disposable income and is used in economic analysis and by policymakers.

    Leverage Ratios for Evaluating Solvency and Capital Structure


    The most well known financial leverage ratio is the debt-to-equity ratio. It is expressed as:

    D/E Ratio = Total Debt / Total Equity

    For example, Macy's has $15.53 billion in debt and $4.32 billion in equity, as of fiscal year
    ended 2017. The company's debt-to-equity ratio is $15.53 billion / $4.32 billion = 3.59.
    Macy's liabilities are 359% of shareholders' equity which is very high for a retail company.

    A 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 a 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
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    good idea to measure a firm's leverage ratios against past performance and with
    companies operating in the same industry to better understand the data.

    The equity multiplier is similar, but replaces debt with assets in the numerator:

    Equity Multiplier = Total Assets / Total Equity

    For example, assume that Macy's (NYSE: M)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. Although debt is not specifically referenced in the formula, it is an underlying
    factor given that total assets includes 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 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):

    ROE = Net Profit Margin x Asset Turnover x Equity Multiplier

    An indicator that measures the amount of debt in a company’s capital structure is the debt-
    to-capitalization ratio, which measures a company’s financial leverage. It is calculated as:

    Long-term Debt to Capitalization Ratio = Long-term Debt / (Long-Term Debt + minority


    interest + 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. The formula, in this case, is:

    Total Debt to Capitalization Ratio = (current liabilities + Long-Term Debt) / (current liabilities
    + Long-Term Debt + minority interest + equity)

    Degree of Financial Leverage


    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:

    DFL can also be represented by the equation below:

    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.

    Consumer Leverage Ratio

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    The consumer leverage ratio is used to quantify the amount of debt 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
    main factor for corporate earnings growth over the past few decades. Others have blamed
    the high level of consumer debt as a major cause of the great recession.

    Consumer Leverage Ratio = Total household debt/ Disposable personal income

    Understanding how debt amplifies returns is the key to understanding leverage, but as you
    can see if comes in several forms of analysis. Debt by itself is not necessarily a bad thing,
    especially if debt is taken on to make larger investments into projects that will generate
    positive returns. Leverage can thus multiply returns - but also magnify losses if returns turn
    out to be negative.

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