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 = Total Debt / Total Equity
  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

Leverage Ratio = Total Debt / Total Equity

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.