Leverage Ratio with Formula and Examples

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This ratio focus on the long-term solvency of the company with regards to how much capital comes in the form of debt or assessing the ability of the company to meet its financial obligation.  We can also say that this ratio measures long-term stability and structure of the firm.

Importance of Leverage Ratio

This ratio helps the company to determine how much amount they can borrow so as to increase the profitability of the company. This ratio also helps in determining the quantum of debt that can be borrowed.

Types of Leverage Ratio

A. Capital Structure Ratio

This ratio provides details about which type of financing to be used so as to focus on long-term solvency position of the company

I. EQUITY RATIO

This ratio indicates total owner contribution in the company.

Formula: Shareholder Equity/ Total Capital Employed

Shareholders Equity = Equity share capital + Reserve and Surplus

Total Capital Employed = Shareholders Equity + Debentures + Long-Term Loan

II. DEBT RATIO

This ratio indicates total leverage used in the company.

Formula: Total Debt/ Total Capital Employed

Total Debt= Short Term and Long Term Borrowings, Debentures and Bonds

III. DEBT TO EQUITY RATIO

This ratio indicates total debt used in the business in comparison to equity. A higher ratio represents insecurity to the creditors and other lenders and the low ratio represents more safety or cushion to lenders.

Formula: Total Debt/ Shareholders Fund

B. Coverage Ratio

This ratio is used to check how much margin is available after paying off the obligation which arises in the course of leveraging the business.

I. DEBT SERVICE COVERAGE RATIO

At the time of leveraging, lenders/banks use this ratio to know whether the company will be able to pay their dues in due course or not. Generally, 1.5 to 2 is treated as an ideal ratio.

Formula: Earning Available for debt service/ Interest + Installments of debt

Earnings Available for debt service = Net Profit after Tax +Non Cash                                                                                               Expenditure + Interest + other                                                                                                Abnormal Adjustment

II. INTEREST COVERAGE RATIO

This ratio is used by the lenders to check whether the company will be able to pay off interest due on the instalment on time or not. This ratio also indicates the extent to which fall in earning won’t impact the payment of interest.

A high ratio means the company can easily meet its interest obligation. A low ratio indicates inefficient operation.  

Formula: EBIT/Interest

Where, EBIT= Earning Before Income And Taxes

III. CAPITAL GEARING RATIO

This is an important tool used to check the capital structure of the company. This ratio describes the relationship between the owner’s capital and the amount borrowed by the company on which periodic payment is made.

Formula: (Preference share capital + debentures + Long term loan) / (Equity share capital + Reserve and surplus)

Example:

ParticularsAmount
Shareholder Equity19802
Total Assets30011
Total Capital Employed21976
Total Debt2174
Earnings Available for debt service4932
Instalment amount364
EBIT4932
Interest25
Preference Share Capital + Debenture + Long Term Loan1321
Equity share capital + Reserve and Surplus491
  • Equity ratio = Shareholder Equity/ Total Capital Employed = 19802/21976 = 0.90:1
  • Debt ratio = Total Debt/ Total Capital Employed = 2174/21976 = 0.10:1
  • Debt to equity ratio = Total Debt/ Shareholders fund = 2174/19802 = 0.11:1
  • Debt Service coverage ratio = Earnings Available for debt service/ (Interest + Installments of debt) = 4932/364 = 13.55
  • Interest Coverage ratio = EBIT/Interest = 4932/25 = 197.28
  • Capital Gearing Ratio = (Preference share capital + debentures + Long term loan) / (Equity share capital + Reserve and surplus) = (1321+491)/ 19802 = 0.09

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