Leverage Ratio Definition

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 category is
important because 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 off its debts as they come due. Several common
leverage ratios are discussed below.

 A leverage ratio is any one of several financial measurements that

assesses the ability of a company to meet its financial obligations.
 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. 
 Common leverage ratios include the debt-equity ratio, equity multiplier,
degree of financial leverage, and consumer leverage ratio.
 Banks have regulatory oversight on the level of leverage they are can hold.
What Does a Leverage Ratio Tell You?
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 may help to fuel growth. Uncontrolled debt levels can
lead to credit downgrades or worse. On the other hand, too few debts can also
raise questions. A reluctance or inability to borrow may be a sign that operating
margins are tight.

There are several different 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
compared to disposable income and is used in economic analysis and by
policymakers.

Banks and Leverage Ratios

Banks are among the most leveraged institutions in the United States. The
combination of fractional-reserve banking and Federal Deposit Insurance
Corporation (FDIC) protection has produced a banking environment with limited
lending risks.

To compensate for this, three separate regulatory bodies, the FDIC, the Federal
Reserve, and the Comptroller of the Currency, review and restrict the leverage
ratios for American banks.1 This means they restrict how much money a bank
can lend relative to how much capital the bank devotes to its own assets. The
level of capital is important because banks can "write down" the capital portion of
their assets if total asset values drop. Assets financed by debt cannot be written
down because the bank's bondholders and depositors are owed those funds.

Banking regulations for leverage ratios are complicated. The Federal Reserve

created guidelines for bank holding companies, although these restrictions vary
depending on the rating assigned to the bank. In general, banks that experience
rapid growth or face operational or financial difficulties are required to maintain
higher leverage ratios.2

There are several forms of capital requirements and minimum reserve placed on

American banks through the FDIC and the Comptroller of the Currency that
indirectly impacts leverage ratios. The level of scrutiny paid to leverage ratios has
increased since the Great Recession of 2007 to 2009 when banks that were "too
big to fail" were a calling card to make banks more solvent. These restrictions
naturally limit the number of loans made because it is more difficult and more
expensive for a bank to raise capital than it is to borrow funds. Higher capital
requirements can reduce dividends or dilute share value if more shares are
issued.

For banks, the tier 1 leverage ratio is most commonly used by regulators.

Leverage Ratios for Evaluating Solvency and Capital Structure

Perhaps the most well known financial leverage ratio is the debt-to-equity ratio.

The Debt-to-Equity (D/E) Ratio

This is expressed as:

Equity Ratio=Total Shareholders’ Equity/Total Liabilities
For example, United Parcel Service's long-term debt for the quarter ending
December 2019 was $21.8 billion. United Parcel Service's total stockholders'
equity for the ending December 2019 was $3.3 billion. The company's D/E for
the quarter was 8.62. That is considered high.3
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 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. Fedex has a D/E ratio of 1.78, so
there is cause for concern where UPS is concerned. However, most analysts
consider that UPS earns enough cash to cover its debts.

The Equity Multiplier

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

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.