Money Matters

What is EBITDA? Leverage Ratios Simplified

Leverage ratios are a powerful way to analyze a company's financial health. be aware of the risks associated with high ratios.

Every company has financial obligations of some sort, and organizations often borrow money in the form of debt to fulfill these obligations. The balance between a company's borrowed debt and accumulated equity can tell you a lot about how that company is doing. This is where leverage ratios come in. 

This article will explore:

  1. What is a leverage ratio?
  2. Common types of leverage ratios
  3. How leverage ratios are used
  4. Why are leverage ratios significant?
  5. Risks associated with high leverage ratios

What Is a Leverage Ratio?

Leverage ratios compare the proportion of debt to the proportion of equity within a company.

An individual may use a leverage ratio to determine the makeup of a company's capital structure and consequently form conclusions about its financial health. Namely, they may use leverage ratios to determine the debt-to-equity ratio of a company. 

Several financial leverage ratios can be considered quite common: these include debt-to-capital ratio, debt-to-equity ratio, and EBITDA ratios. These various types of leverage ratios are explained in depth below.

The leverage ratio of a given company can reveal how much of its finances must be paid back to lenders and how much of its total assets the company actually owns.

Common Leverage Ratios Explained

Debt-to-equity and debt-to-capital

  • Debt-to-equity: A prevalent leverage ratio compares a company's total debt relative to its total equity. This leverage ratio is used to examine a company's balance sheet to understand how debt affects its ability to sustain itself. 
  • Debt-to-capital: This ratio works similarly but takes total capital into account, consisting of equity and other valuable assets the company owns, such as equipment and supplies. 

Typically, the higher these ratios are, the more debt they use to finance their operations as an institution. This means that two companies with similar net worths may have entirely different debt-to-equity or debt-to-capital ratios depending on how much of their net income is derived from accounts payable or debt. 

EBITDA ratios

EBITDA ratios analyze a given company's ability to pay off its debt. Credit agencies develop these ratios to determine how long it would take an organization to eliminate its incurred debt. 

The term EBITDA is an acronym for a larger equation that can be manipulated to derive this sentiment. The acronym stands for: Earnings Before Interest, Taxes, Depreciation, and Amortization.

How Are Leverage Ratios Used?

Leverage ratios, as stated above, are primarily utilized for analysis regarding a company's total assets. Two companies with the same net worth may derive their capital gains from entirely different places, and leverage ratios attempt to underline that distinction. 

How banks use leverage ratios

Banks use leverage ratios to determine the viability of a company's finances. When a company goes to a bank to request a loan, it will be audited for several reasons: 

Bank will evaluate how a company has accumulated its assets
This is the primary reason a bank would use leverage ratios. Suppose a company's financial statements reveal that most of its assets have been accumulated through debt. In that case, the bank may find the company less suitable for a new loan. 
Bank may assess a company's ability to pay back a loan
Similarly, suppose the financial statements of a given organization reveal that they have previously struggled to pay back loans on time. In that case, they may lose viability and be turned down for a new loan as a result. 

How investors use leverage ratios

A company's debt may also deter investors from investing in it and steer them towards direct competitors. Suppose an investor decides between two similar companies and sees that one company has higher debt ratios. In that case, they may be more apt to choose the other organization. 

However, using debt to leverage a financial situation is not inherently harmful. A company's ability to earn large loans may demonstrate strength in the product or integrity they've achieved with the bank that gave them the loan. In other words, seeing a company leverage its value with debt may lead you to believe their future is bright enough to earn the trust of the bank that entrusted that loan to them. 

There are several reasons why investors would be interested in knowing a company's leverage ratio:

Investors can determine a company's financial health
Firstly, leverage ratios allow retail investors to inspect the inner workings of a firm's financial situation. If the firm demonstrates high leverage, they have more debt than equity. They, therefore, may not be deemed suitable as a short-term investment.
Investors can analyze how long a company has held its debt
Investors can also analyze how the company's debt has been taken care of through repayment. Suppose the leverage ratio has stayed high for a while. In that case, an investor may feel that long-term debt will continue to accrue and may choose to invest elsewhere.
Investors can analyze historical fluctuations of leverage ratios
Doing so can allow them to understand cash flow statements better as well. For example, cash flow may have been progressing steadily until a recent point. Investors may then examine the company's leverage ratios to see what their proportion of debt has recently been. If the leverage ratio has increased, one may assume that the company has taken on more debt, perhaps in business loans.

Typically, higher leverage ratios are associated with a higher proportion of debt to equity and vice versa for low leverage ratios.

Why Are Leverage Ratios Significant?

As detailed above, leverage ratios can be significant for many reasons: 

  • An accounting firm may monitor a company's leverage ratio during an audit to ensure no suspicious activity occurs. For example, suppose a leverage ratio drops drastically and suddenly. In that case, an accountant may delve deeper into the situation to make sure no illegal transactions were made to lower the company's debt.
  • Financial institutions that intend to create loans for businesses may be more willing to do business with a company that has not exhibited issues with its leverage ratios.
  • Investors use leverage ratios to understand how companies have accrued their value. 
A note about leverage ratios
Companies may calculate their leverage ratios differently. For example, Apple may include a specific account that another company may exclude in its calculation. These small differences can create big changes in leverage ratios and can make two companies less comparable.  As a solution, many analysts will look to companies' balance sheets and calculate leverage ratios themselves (ignoring any ratios precalculated by a company). This way, they make sure that two different companies' leverage ratios are measuring the same things.

To understand this concept in further detail, let's look at an example.

Example: an investor comparing 2 companies

Jeffery is a retail investor who is interested in buying shares of stock in a tech company. After lots of research, he discovers two companies developing a new CRM software that will automate significant marketing decisions for business owners.

Jeffery is excited about the software but torn between which of the two companies will produce more profitability. In hopes of deciphering which firm will yield a higher return on investment, Jeffery takes a closer look at each company's financial statements.

  1. Jeffery begins by looking at both companies' balance sheets and finds that although each company has a similar net worth, Company A has a massive figure listed under accounts payable. 
  2. Taking this into consideration, Jeffery concludes that Company B has earned its wealth by obtaining assets rather than asking for loans.
  3. Understanding that Company A will eventually have to pay back these loans, he decides to pick Company B in hopes that they use the extra funds to distribute dividends to their shareholders.

Risks Associated with High Leverage

High leverage situations can be interpreted as inherently high risk because they are driven by debt. 

Suppose a company begins to collect debt...

In this case, they start to rely on liabilities which grow increasingly as interest rates take effect. Therefore, a company with no leverage may perform better than their counterpart with lots of debt because they do not have to pay off lenders and can instead keep their profit/distribute it out to shareholders in the form of dividends. 

A company's retained earnings are defined by the money they keep once all their expenses and dividends are paid. A company may accumulate debt to purchase assets like technology and other supplies. Still, they may eventually have to pay elevated prices for it down the road. Therefore, as explained in the example above, it can be more favorable to obtain the same net worth as your competitor with lower amounts of leverage.

So, how does a company balance leverage?

There must be an equilibrium point in which leverage is minimized and production is maximized from the firm's perspective. This optimal point of return mitigates the use of debt in corporate debt. It, therefore, minimizes debt for shareholders and investors as well.

Key Takeaways

  • Companies fund their operations in different ways. Some companies need loans to sustain themselves before they become self-sufficient.
  • Leverage ratios determine how much debt companies use, in comparison to the assets they own, to sustain themselves.
  • The higher a leverage ratio is, the more a company relies on accounts payable, or debt, to maintain their business.
  • High leverage ratios are not inherently bad. An investor may want to closely examine why a company has low or high leverage ratios before using it as a reason to/not to invest.

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