Leverage Unit 4 FM

Leverage Ratio Formula
Leverage ratio can be defined as the ratio of total debt to total equity of any firm to
understand the level of debt being incurred by any firm or entity.
Example #1
Let’s take an example of company X, whose Total Debt is $200000 and Total
Equity is $300000. Calculate the Leverage Ratio of a company.
Solution: We can calculate the Leverage Ratio by using the below formula
Leverage Ratio = Total Debt / Total Equity

Example #2
Let us take the example of Reliance, whose Total Shareholder equity is Rs 3,14,632
Cr, long-term debt is Rs 81,596 Cr, and short-term debt is Rs 15,239 Cr. Calculate
the Leverage Ratio of a Reliance company.

Solution:
Hence we don’t have Total Debt, so first, we will find out the Total Debt
We can calculate the Total Debt by using the below formula
Total Debt = Long-Term + Short Term
Hence now will find out the Leverage Ratio
We can calculate the Leverage Ratio by using the below formula

 Leverage Ratio = Rs 96,835 Cr / Rs 3,14,632 Cr
 Leverage Ratio = 0.31
Example #3
Let us take the example of the company Tata Steel whose Total Shareholder equity
is Rs 61,514 Cr, long-term debt is Rs 24,568 Cr and short-term debt are Rs 670 Cr.
Calculate the Leverage Ratio of a Tata Steel company.

Solution:
Hence we don’t have Total Debt, so first, we will find the Total Debt.
We can calculate the Total Debt by using the below formula
Total Debt = Long-Term + Short Term

We can calculate the Leverage Ratio by using the below formula

Explanation of Leverage Ratio Formula
Leverage ratio can be defined as the ratio of total debt to total equity of any firm to
understand the level of debt being incurred by any firm or entity. Debt is an essential
component for any firm as it is significantly cheaper than other forms of money and
amplifies profits. On the other hand, a higher-leveraged company can face issues if
there is a decline in the business of the company. So leverage can reap benefits if used
well or create risk for a company if not properly utilized.
There are various kinds of leverage ratios. Some are debt/equity, debt/EBITDA,
debt/assets, or debt to total capital. Debt/Equity is a common measure used by
investors. There are various ways in which leverage is created for a company: –
1. A company might take debt to purchase assets such as property, plant, or equipment.
2. A company borrows debt for short-term requirements, such as inventory, liquidity, etc.
3. A company might borrow to finance an acquisition of another company.
4. A private equity firm does Leveraged Buyouts.
5. An individual may borrow to finance his/her purchase of a house.
6. Investors in equity markets may borrow to add stocks to their portfolios.
Increasing leverage can multiply earnings for an individual or a company. But it also
comes with the warning of additional risk. If the cash flows do not support it, then there
is a chance of the company or individual defaulting on their payments. Hence the level
of leverage should be defined wisely.
Relevance and Uses

The leverage ratio is an indicator of the inherent risk of a company. When the debt
ratio is very high compared to its peers, the firm is carrying a significant burden since
the principal and interest payments would be blocking the company’s cash flows.
These cash flows could have been used for capital expenditure or other important ways
to grow the company. Also, there are possible circumstances where the cash flows are
not large enough to support the debt payments. Then the company might have to
default.
Conversely, if any company’s debt level is low, the debt payments do not amount to a
large portion of the company’s cash flows; hence, they are not sensitive to external
circumstances such as business changes. But it also indicates the company can increase
its debt level because debt is cheaper than other forms of money. Each company has to
find its optimum level of debt to support.
But there is no optimum level of debt for any particular company. Leverage ratios
should be compared with companies operating in a similar industry. For example, steel
companies generally have a higher level of debt than other industries. Hence when
looking at the debt level of any steel company, it should only be compared with its
peers. If the debt level exceeds its peer companies, there may be a cause for concern.
Both investors and lenders to any particular firm prefer lower leverage levels since it
guarantees that their interests are protected in case of a decline in the company’s
business or even during default or liquidation. This is one of the reasons why higher
leverage ratios may prevent any firm or company from attracting additional capital.

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Leverage Ratio Formula

understand the level of debt being incurred by any firm or entity.

Equity is $300000. Calculate the Leverage Ratio of a company.

Leverage Ratio = Total Debt / Total Equity

the Leverage Ratio of a Reliance company.

We can calculate the Total Debt by using the below formula

Total Debt = Long-Term + Short Term

Hence now will find out the Leverage Ratio

We can calculate the Leverage Ratio by using the below formula

 Leverage Ratio = 0.31

Calculate the Leverage Ratio of a Tata Steel company.

We can calculate the Total Debt by using the below formula

Total Debt = Long-Term + Short Term

Leverage Ratio = Total Debt / Total Equity

well or create risk for a company if not properly utilized.

debt/assets, or debt to total capital. Debt/Equity is a common measure used by

3. A company might borrow to finance an acquisition of another company.

4. A private equity firm does Leveraged Buyouts.

5. An individual may borrow to finance his/her purchase of a house.

6. Investors in equity markets may borrow to add stocks to their portfolios.

of leverage should be defined wisely.

Relevance and Uses

find its optimum level of debt to support.

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