What Are Leverage Ratios And How Do Banks And Companies Utilize Them?

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Leverage ratios are financial ratios used to evaluate how much capital is financed through debt and equity. It is used to assess the business' ability to pay off its debt, especially if it wants additional capital from borrowing. High leverage ratios indicate that a company is mostly funded by debt instead of equity, which can trigger a default if cash flows are not appropriately handled. 

On the other hand, very low ratios could mean that the business is hesitant to pursue borrowing due to the tight operating margin or can be that it has enough retained earnings to finance expansion or new projects. 

Banks and other lenders scrutinize leverage ratios if a company or borrower can pay its debt when due. It can also be a factor in considering a company's overall valuation for investors or potential buyers. 

Discussed below are the different types of leverage ratios commonly utilized in assessing the leverage of a company. 

1. Debt / EBITDA Ratio 

The Debt/EBITDA Ratio is used to assess the company's ability to pay financial debt or interest- bearing financial obligations (exclude accounts payables or provisions). For a manufacturing company, a Debt/EBITDA ratio of 2x is the industry standard, which means having a 1.2x ratio could suggest that the company is in an excellent position to acquire debt for additional capital. However, a ratio of 2.5x can give a red light to the banks and other financial institutions, doubting the business capability to handle additional debt. The Debt/EBITDA ratio is computed by dividing the financial debt over EBITDA (Earnings Before Interest, Tax, Depreciation, Amortization). 

Debt/EBITDA Ratio = Financial Debt/EBITDA 

2. Net Debt/EBITDA Ratio 

The Net Debt/EBITDA ratio is quite similar to Debt/EBITDA, depending on the financial debt. Cash & cash equivalents are deducted from the debt in computing for the Net Debt/EBITDA ratio, assuming that cash will be used to pay the financial debt. It is then computed by taking the net debt (Financial Debt less Cash & Cash Equivalents) divided by EBITDA. This ratio can be translated as the number of years that the business needs to pay its debt, given that the net debt and EBITDA are constant. For example, let's take that the company's Net Debt/EBITDA ratio is 3.5x, which means that it will take three and a half years to repay the financial debt utilizing the EBITDA. 

Net Debt/EBITDA Ratio = (Debt – Cash & Cash Equivalents) / EBITDA 

3. Interest Coverage Ratio 

Evaluating the company's capability to pay the interest debt can be done by looking at the interest coverage ratio. It is computed by taking the EBIT (Earnings Before Interest and Tax) divided by the interest expense. This ratio shows how many times the EBIT covers the interest expense. The higher the ratio, the better it is for the company since the interest expense will not affect much of its earnings. The interest coverage ratio is a leverage ratio to measure its current debt-paying capability and future borrowings. 

Interest Coverage Ratio = EBIT / Interest Expense 

4. Debt Service Coverage Ratio 

Debt service coverage ratio (DSCR) is utilized to assess the capability of the business to cover its debt service (Debt Repayment + Interest Payment) by the Free Cash Flow to Firm (FCFF). FCFF is the operating cash flow available after considering the CAPEX, working capital changes, and taxes. It is computed by dividing the Free Cash Flow to Firm over the Debt Repayment + Interest. 

Debt Service Coverage Ratio = Free Cash Flow to Firm / (Debt Repayments + Interest) 

5. Debt Ratio 

The debt ratio is a leverage ratio used to evaluate how much of the liabilities are financed by debt. It is computed by dividing the total liabilities over the total assets. A low debt ratio suggests that the business is not highly leveraged and mostly financed through equity. The high debt ratio alerts the financers since it makes the company susceptible to financial turmoil and economic risks. 

Debt Ratio = Total Liabilities / Total Assets 

6. Debt/Equity Ratio 

The debt/equity ratio is used to measure the debt's percentage out of the total investment. It also evaluates if the shareholders' equity can cover its interest-bearing debt. The debt/equity ratio is computed by taking the interest-bearing debt, divided by total shareholder equity. Using a modest debt to finance the operation can increase returns for the company, given that the cost of debt is lower than the investors' expected rate of return

Debt/Equity Ratio = Interest-Bearing Debt / Equity 

Leverage Ratio Conclusion

Leverage ratios can be beneficial both for the companies and lenders to evaluate its availability to finance its current financial obligation and further borrowing for business expansion. Healthy leverage ratios are a turn-on for the lenders, given that the other financial ratios and metrics adhere to their standard. Leverage ratios are a useful add-on to the financial analyses for better decision-making and financial planning. Make sure to keep them in mind for future investment, valuation, and lending considerations.

Lellith Garcia is the Marketing Manager of eFinancialModels.com, which provides a rich inventory of industry-specific financial model templates in Excel spreadsheets. Lellith has been involved in preparing various financial model templates, which are loved by entrepreneurs, consultants, investors, and financial analysts looking for assistance to speed up their financial modeling tasks.

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