Leverage ratios compare the owners' investment in the business to money borrowed. Businesses are said to have high leverage when they use a large amount of borrowed money compared to the amount put into the business by the owners. Leverage is similar to a home mortgage: If you borrow 70% of the cost of a $100,000 house, for example, and sell it for twice what you paid, you only have to pay the bank $70,000; you get to keep the remaining $130,000. Thus, you can make a 333% profit ($100,000 profit on a $30,000 investment) when the price of your house doubles.
One principal measure of leverage is the debt-to-equity ratio. It is the ratio of total liabilities to total equity.
Total liabilities includes all current and long-term liabilities: accounts payable, taxes due, and short-term bank debt as well as long-term borrowings.
A ratio of 1:1 indicates that there is as much capital as debt invested in the business; a ratio higher than 1:1 means there is more debt than capital and a ratio lower than 1:1 means there is more capital than debt.
Highly leveraged businesses may have high fixed costs because of the interest they must repay. Consequently, more of the business risk is borne by the lenders as compared to the owners, the owners can maintain control of the business with less investment on their part, and the return to the owners can be magnified once the business earns more than is required to repay the lenders.
Business with low leverage ratios, in contrast, are less risky, require a greater investment by the owners to maintain control of the company, and will show smaller increases in profit to the owners for corresponding increases in volume.
Who's Watching:
Bankers and other lenders are interested in the debt-to-equity ratio because it tells them how much investment the owners have made. Generally, lenders want a substantial investment by the owners, because that protects their loan. They do understand, however, that long-term debt provided by the owners is similar to equity, since the bank debt will be paid first.
Business Factors:
Whether your company's debt-to-equity ratio is high or low depends on the business you are in. Some businesses, banks for example, safely have very high debt-to-equity ratios, while others, such as heavy manufacturers, have lower ratios. It also depends on your amount of fixed assets, since lenders often like to have some fixed assets as collateral for their loans.
Accounting Factors:
Sometimes the owners of a business lend it money, rather than buy stock. There are many good reasons for doing this, such as receiving interest payments that are tax deductible to the company. Since these loans are to the owners and are often subordinated to other borrowings, they are really not much different from equity, at least in the view of an outside lender.
Note also that the debt-to-equity ratio includes all liabilities, some of which are current operating liabilities rather than specific borrowings.
