Financial Leverage, Leverage Metrics (Gearing Ratios)
How to Calculate Financial Leverage and Apply Leverage Metrics, Step by Step

Leverage metrics show how a firm's owners and creditors share business risks and rewards. When business performance is strong,

Leverage metrics compare funds lenders supply to business to funds owner/investors supply.

What are Financial Leverage Metrics?

Financial leverage is a tactic by which individuals and companies increase their earning power through borrowing.

Some business people call leverage metrics gearing ratios. This name clearly points to the analogy with mechanical leverage:

Humans and machines use mechanical leverage to amplify their lifting power by configuring levers, gears, or pulleys to trade off movement and force.
Investors and owners use financial leverage to amplify their earning power by borrowing funds that increase their investment stake.

In other words, businesspeople use leverage when they expect to earn more from the funds they borrow, than the cost of borrowing.

Owners, financial officers, and investors know that leverage comes with potential rewards but also potential risks. As a result, they take a keen interest in measuring leverage strength or equivalently, level of leverage, or leverage exposure. For this, they rely on a family of leverage metrics—the subject of this article.

Define Leverage, Measure Leverage

Financial analysts define leverage in practical, easy-to-measure terms. The definition refers specifically to the sources of funds that firms use to acquire assets, which are either owners or creditors. To measure leverage, the analyst compares the funds that creditors supply to a firm, to the funds that owners supply.

Each of the 5 leverage metrics below makes this comparison in its own way. All of these metrics will show when creditors provide substantially more funding than owners, and in such cases, the firm is operating with high leverage.

To the analyst, leverage metrics measure the increase in earning power a firm can expect from borrowing, when the business is doing well. And, the same leverage metrics show how the firm loses earning power when business is doing poorly.Both creditors and owners share enterprise risks and rewards, but in proportion to their share of the funding. Thus, when a high leverage business fails, creditors have more to lose than owners.

Why Do Firms Use Leverage?

Why do profitable firms borrow funds when they can continue operating without doing so? The answer has to do with the ways that firm invest in their own businesses. Borrowing results in leverage, which can increase the profitability of the firm's investments.

In a strong economy or when the business is otherwise doing well, owners may earn more on funds they borrow than they pay for the cost of borrowing. This in fact is the reason owners use leverage. When business is healthy, leverage increases earning power.
The reverse can be true in a poor economy or if the firm performs poorly for other reasons. As a result, earnings may not even cover interest due on loans. In this case, borrowing costs are therefore especially burdensome for owners. This is because leverage decreases earning power when business is poor.

Capital Structure and Financial Structure

Note that the leverage metric Long-Term Debt-to-EquitiesRatio equates to the firm's capital structure. Similarly, the Total Debt to Equities Ratio metric is essentially equivalent to the firm's financial structure. The two structures and these two debt-to-equities ratios provide different ways to compare equity funding to debt funding.

Incidentally, it is correct to write the names of these ratios with or without hyphens. This article uses hyphens but sources that omit hyphens are equally correct.

Measuring and Interpreting Leverage in Context

This article further explains and illustrates the debt-to-equities ratios, along with three other frequently used ratios (leverage metrics) that also compare the firm's funding sources. Explanations and calculations show how to use and evaluate each metric in context with the others.

Five steps in the following Sections explain how to calculate and interpret the following leverage metrics:

Total debt-to-assets-ratio (Debt ratio).
Total debt-to-equities ratio.
Long-term debt-to-equities-ratio.

Equity-to-assets ratio.
Times-interest-earned.

What are financial leverage metrics?
The role of Leverage and other metrics in finance and business analysis.
How to calculate leverage and interpret financial leverage metrics (gearing ratios) in 5 steps.
Example Income statement data for leverage metrics.
Example Balance sheet data for leverage metrics.

Resources

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Leverage Ratios, Other Business Finance Metrics
Business Ratios as Leverage Metrics

Leverage metrics are a financial metrics family—one of six metrics families that business people call either Financial Statement Metrics or Business Ratios. Generally, these metrics use figures from financial reports to assess the firm's financial performance and financial position. Metrics Input data come primarily from four financial accounting reports:

Four financial statement reports are primary input data source for business ratio metrics.

Some businesspeople refer to all financial statement metrics as "business ratios." That is because they calclulate most of these metrics by dividing one financial statement figure into another. Language purists note, however, that a few of these metrics are not ratios. The Working capital metric, for instance, is the difference between two Balance sheet figures, not a ratio.

Who Uses Financial Statement Metrics? For What purpose?

Several groups take a keen interest in financial statement metrics.

Investors and investment analysts carefully weigh the firm's financial statement metrics when they consider trading bonds or shares of stock.
The firm's officers and managers use financial statement metrics to identify strengths, weaknesses, and target levels for business objectives.
Shareholders and boards of directors depend on these metrics for evaluating management performance.

Meet Six Families of Financial Statement Metrics

Each financial statement metrics family addresses one kind of question about the firm and its finances. The six metrics families and the kinds of questions each addresses are the following.

Leverage metrics (the subject of this article).
Leverage metrics ask: How do owners and creditors share risks and rewards?
Profitability metrics.
Profitability metrics ask: is the firm earning acceptable margins?
Growth metrics.
Growth metric sask: Are revenues, profits, and market share growing?

Activity and efficiency metrics (the subject of this article).
Activity metrics ask: Does the firm use resources efficiently?
Liquidity metrics.
Liquidity metrics ask: Can the firm meet its near-term spending needs?
Valuation metrics.
Valuation metrics ask: What are the firm's prospects for future earnings?

Sections below illustrate popular Leverage metrics. Links immediately above for other metrics families lead to similar coverage on other pages for Profitability, Growth, Activity, Liquidity, and Valuation metrics.

How to Calculate and Interpret Leverage Metrics (Gearing Ratios) in 5 Steps

The sections below present five leverage metrics that are central in business analysis today. The text explains the essential meaning of each metric, shows example calculations, and discusses rules of thumb for interpreting metrics results.

Find input data for Leverage Metrics in two financial reports:

Calculate leverage metrics such as debt-to-equity from Income Statement and Balance Sheet figures

Measuring Leverage Step 1
Calculate Interpret total Debt-to-Assets Ratio (Debt Ratio)

The firm out of business pays off creditors before paying off owners

Can the company pay off its creditors in case the business fails?

The total debt to assets ratio addresses this question. This metric is the simple ratio of two Balance sheet figures in its name, total debt (total liabilities) and total assets.

The Balance sheet equation ensures that the total assets equates to the firm's total funding. In other words, Total Assets = Total Liabilities + Total Equities
Creditors provide the "Total Liabilities" portion of Total funding.

In other words, the total debt-to-asset ratio indicates directly whether or not the asset base covers the firm's total debt. A Total-Debt/ Asset ratio less than 1.0 says to creditors that asset value is sufficient to pay off the debt.

Calculating the Total Debt-to-Assets Ratio.

The ratio name describes the calculation. Note also that this example uses figures from the Exhibit 3 Balance sheet below.

Liabilities total: $8,938,000
Assets total: $22,075,000

Total debt-to-asset ratio
     = Total liabilities / Total Assets
     = $8,938,000 / $22,075,000
     = 0.405

The result 0.405 means that creditors supply 40.5% of the company's funding. And, this means of course that owners supply the remaining 59.5%.

Total Debt-to-Assets Ratio Rule of Thumb.

When a firm approaches lenders asking for still more funding, potential creditors will compare the debt/assets ratio to the industry average. They will probably also compare the firm's debt/equity ratios (steps 2 and 3, below) with industry averages. If these ratios seem exceptionally high, lenders may require the firm to raise more equity capital before lending. This is because increasing equity capital does the following:

Raises the asset base.
Lowers the debt ratio.
Provides greater security for lenders if the business fails.

Measuring Leverage Step 2
Calculate, Interpret Total Debt-to-Equity Ratio

Bank loans are a primary source of debt funding for firms in private industry.

Describe the firm's financial structure with a single ratio

Debt to equity ratios measure leverage levels directly. These ratioss mirror the textbook definition of leverage—they simply compare owner funding contributions directly to creditor contributions.

Two debt to equities ratios are especially important.

Firstly, the Total debt to-equities ratio (this section, Step 2).
Secondly, the Long-term debt-to-equities ratio (next section, Step 3).

Analysts regard the Total debt-to-stockholders-equities ratio as the stronger of these. This is because the ratio using "total debt" provides a more conservative view of creditor protection. By contrast, The Long-Term debt-to-equities ratio simply compares the two Balance sheet entries in its name by using them in a ratio.

Note that total liabilities means the sum of both long-term and short-term debt. "Debt" for this ratio therefore includes long-term-loans, for acquiring assets, but also short-term-debts the firm owes to suppliers, employees, and tax authorities. In addition, short-term debt also includes interest payments due in the current period.

Analysts view the Total debt-to-equities ratio measure of leverage as a stand-in for the term financial structure. Financial structure is simply another name for a comparison of total debt funding to equity funding.

See the article Capital and Financial Structure for examples showing how to use Debt/Equity ratios to forecast the impact of leverge on gain or loss of earning power.

Calculating the Total Debt-to-Equities Ratio.

The ratio name describes the calculation. Note that this example uses figures from the Exhibit 3 Balance sheet below.

Liabilities total: $8,938,000
Stockholders equities total: $13,137,000
Total debt to equities ratio
     = Total liabilities / Total stockholders equities
     = $8,938,000 / $13,137,000
     = 0.680

Measuring Leverage Step 3
Calculate Long Term Debt to Equities Ratio

The company's debt includes interest and payoff due bondholders

Describe the firm's capital structure with a single ratio

The second debt-to-equities ratio, Long-term debt-to-stockholders-equities (or simply Long- term debt-to-equities) is a truer measure of leverage than the ratio above in Step 2.

That is because the debt figure here includes only debt to lenders, or long-term debt. By contrast, the total debt figure above also includes short-term debt, such as wages the firm owes to employees or Accounts payable the firm owes to its suppliers.

As a result, this ratio equates to the firm's capital structure. This is because capital structure simply refers to a comparison of long-term debt to equity funding. Here, "debt" refers mostly to loan debt for acquiring income-earning assets.

See the article Capital and Financial Structure for examples showing how to use Debt/Equity ratios to forecast the impact of leverge on gain or loss of earning power.

Calculating the Long-Term Debt-to-Equities Ratio

The ratio name describes the calculation. Note also that this example also uses figures from the Exhibit 3 Balance sheet below.

Long-term liabilities total: $5,474,000
Stockholder's equities total: $13,137,000
Long-term debt-to-equities ratio
     = Total long-term liabilities / Total stockholders equities
     = $5,474,000 / $13,137,000
     = 0.417

Two Debt-to-Equities Ratios, Same Rules of Thumb

In summary, the Long-term debt-to-equities ratio represents the firm's capital structure, while the Total debt-to-equities ratio represents its financial structure. Both structures compare the firm's equity funding to its debt funding.

Averages for both debt to equities ratios vary widely between industries and between companies.

Many firms in capital asset-intensive industries such as heavy manufacturing, purchase assets primarily with borrowed funds. This often leads to debt/equity ratios greater than 1.0. In some cases, these ratios may be as high as 2.0 – 4.0.
In less capital intensive industries, such as the technology industries, funding typically comes primarily through equity sales and retained earnings. Here, debt/equity ratios are more often on the order of 0.2 – 0.5.

When a firm with substantial debt approaches a creditor, asking for still more funding, lenders normally consider several factors immediately:

Potential lenders compare the firm's total debt-ratio and its two debt-to-equities ratios to industry standards.
They also consider carefully the individual sources of existing debt, including actual costs of debt service.

In such cases, lenders will also focus on two kinds of questions.

Firstly, can the firm add more debt and still continue to service its debt? And, can it do so, even if the economy worsens, or business performance weakens?
Secondly, does the firm have enough collateral to protect lenders in case the business fails?

Measuring Leverage Step 4
Calculate, Interpret Equity-to-Assets Ratio

Is the firm carrying too much or too little debt?

The Equity-to-assets ratio is one more rather direct measure of leverage. This metric makes a ratio of the two Balance sheet figures in its name to show the proportion of total assets that have equty funding.In other words, tequity-to-assets ratio provides a direct answer to the question: What proportion of the firm's assets to owner-investors own.

Investors view the equity-to-assets ratio as an indicator and decision guide for three issues that concern them. The ratio serves as:

Another measure of leverge. The lower the ratio, the greater the level of leverage.
An indicator that the firm may be carrying too much debt or too little debt.
Another indicator (besides the Debt/Asset ratio) that indicates the extent to which owner investments are at risk in case the company fails and goes into liquidation.

Note that the Equity-to-assets ratio is the complement to Leverage Metric in Step 1 above, the Debt-to-assets ratio. The complementary relationship between the Step 1 ratio and the Step 4 ratio is simply:

Equity-to-assets complement
= (1.0 - Total Equities) / (Total Assets)

The complement, of course, refers to funds not coming from owners. As a result, the complement refers to funds from lenders.

Calculating the Equity-to-Assets Ratio.

The ratio name describes the calculation. Note also that this example uses figures from the sample Balance sheet below.

Assets total: $22,075,000
Stockholders equities total: $13,137,000
Equities to assets ratio
     = Total equities / Total assets
     = $13,137,000 / $22,075,000
     = 0.595 or 59.5%

Thus, 59.5% of the company's assets funding comes from equities. The complement of this figure shows the funding percentage from creditors.

Equity to assets ratio complement
     = 1.0 - Equity / Assets
     = 1.0 – 0.405
     = 0.405 or 40.5%.

Equity-to-Assets Rules of Thumb

Investment analysts will compare the company's equity/assets ratio with the ratios of other companies in the same industry. Here, they will classify the ratio either as good, barely acceptable, or poor. The real question is whether the firm is carrying too little debt or too much debt:

Too much debt, means the company risks being unable to pay interest due for bank loans and bonds.
Too little debt, means the company may be missing opportunities to leverage growth with borrowed funds.

To fully evaluate the firm's equity/asset ratio, analysts will try to assess the business risk and financial risk facing Grande at this level of leverage. They will also consider carefully Grande's growth prospects for growth.

Measuring Leverage Step 5
Calculate, Interpret Times-Interest-Earned

When a high leverage company attempts to borrow still more, potential lenders turn to lverage metrics to decide whenter the customer can manage additional debt.

Can the company still service its debt if its earnings decrease?

The times-interest-earnedmetric addresses this question. As a result, this metric represents a measure of the firm's credit worthiness.

The Times-Interest-Earned metric is a simple ratio of two Income statement figures. Here, an "Income" figure is simply divided by interest expense. Note that the "income" figure for the Times-Interest-Earned metric does not reflect expenses for extraordinary items or taxes.

Calculating-Times-Interest Earned.

Note especially that the Exhibit 2 Income statement below provides data for this example,

Earnings before tax
and extraordinary items: $2,737,000
Interest expense: $511,000

Times-Interest-Earned
     = Earnings before tax and extraordinary items
                + interest expense) / interest expense
     = ($2,737,000 + $511,000 ) / $511,000
     = 6.36

Notice that the Income statement figure for "Earnings before tax and extraordinary items" already omits interest expense. The numerator of this ratio, therefore, adds back interest expense.

Times-Interest-Earned Rules of Thumb.

Potential lenders will read the firm's times-interest earned ratio in context with its overall financial position. Their primary concern is whether or not the firm can service additional interest payments and still make acceptable profits. In this regard, the generally prefer a higher ratio over a lower ratio. An extremely high ratio, however, may indicate that the company is missing opportunities to use leverage.

Example Income Statement
Including Input Data For Leverage Metrics

The example Income statement below in Exhibit 2 provides data for one of the leverage metrics above: Times-interest-earned.

Grande Corporation Figures in $1,000's Income Statement for Year Ended 31 December 20YY
Revenues Gross sales revenues Less returns & allowances Net sales revenues Cost of goods sold Direct materials Direct labor Manufacturing Overhead Indirect labor Depreciation, mfr equipment Other mfr overhead Net mfr overhead Net cost of goods sold Gross Profit	5,263 360 4,000	33,329 346 6,320 6,100 9,623	32,983 22,043 10,940
Operating Expenses Selling expenses Sales salaries Warranty expenses Depreciation, Store equip Other selling expenses Total selling expenses General & Admin expenses Administrative salaries Rent expenses Depreciation, computers Other general & admin expenses Total general & admin exp Total operating expenses Operating Income Before Taxes	4,200 730 120 972 1,229 180 179 200	6,022 1,788	7,810 3,130
Financial revenue & Expenses Revenue from investments Less interest expense Net financial gain (expense) Income before tax & ext items Less income tax on operations Income before extraordinary items		118 511	(393) 2,737 958 1,779
Extraordinary Items Sale of land Less initial cost Net gain on sale of land Less income tax on gain Extraord items after tax	610 145	465 118	347
Net Income (Profit)			2,126

Exhibit 2. An Example Income statement with data for the leverage metric Times-interest-earned.

Example Balance Sheet
Including Input Data For Leverage Metrics

The example Balance sheet in Exhibit 3 below provides data for leverage metrics.

Grande Corporation Figures in $1,000's Balance Sheet at 31 December 20YY
ASSETS Current Assets Cash Short-term investments Accounts Receivable Less allowance doubtful accts Net accounts receivable Notes receivable short-term Inventories Raw materials Work in progress Finished goods/merchandise Operating & office supplies Total Inventories Prepaid exp, insurance, def taxes Total Current Assets	1,969 137 611 1,692 3,664 19	1,369 137 1,832 20 5,986 265	9,609
Long Term Investments and Funds Common stock held Preferred stock held Bonds Held / Sinking funds Other Long Term Investments Total Long Term Investments		493 184 364 419	1,460
Property, Plant & Equipment Factory Manufacturing Equipment Less accumulated depreciation Net factory mfr equipment Store Equip / Selling Assets Less accumulated depreciation Net store/selling equipment Computer systems Less accumulated depreciation Net computer systems Total Property, Plant & Equip	5,983 2,782 5,456 1,292 4,721 2,370	3,201 4,164 2,351	9,716f
Intangible Assets Copyrights Trademarks and Patents Goodwill Total Intangible Assets		1,014 108 100	1,222
Other Assets Total Assets			68 22,075
LIABILITIES Current Liabilities Accounts payable Notes payable, short-term Current portion of long-term debt Accrued expenses, Interest payable Unearned revenues Taxes payable Other withholding Total Current Liabilities		1,642 912 349 146 274 141	3,464
Long Term Liabilities Bank notes payable Bonds payable, other LT liabilities Total Long Term Liabilities Total Liabilities		912 4,562	5,474 8938
OWNERS EQUITY Contributed Capital Preferred stock Common stock Contributed capital excess of par Total Contributed Capital Retained Earnings Total Owners Equity	3,798 4,184 1,457	9,439 3,698	13,137
Total Liabilities and Equities			22,075

Exhibit 3. Leverage metrics take input data from this example Balance sheet.