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Leverage Ratio

Learn the Steps to Measure Financial Risk with Leverage Ratios

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Leverage Ratio

Key Learning Objectives
  • Conceptually, what is a leverage ratio?
  • How is a leverage ratio different from a coverage ratio?
  • What are the risks associated with high leverage ratios?
  • What are some examples of common leverage ratios used in practice?

Understanding Leverage and Debt Financing

Companies require capital to operate and to continue providing their products/services to their customers. For a certain period of time, the cash generated by the company and the equity capital contributed from the founder(s) and/or outside equity investors could be enough.

However, for companies attempting to reach the next stage of growth by pursuing more ambitious plans for expansion, obtaining more market share, expanding their geographical reach, and partaking in M&A, debt financing can often become a necessity.

Capital Structure Components

The standard composition of a company’s capital structure consists of:

  1. Common Shares: The most basic level of corporate ownership that typically come with voting rights – i.e. the lowest priority ownership claim in a company.
  2. Preferred Shares: Considered to be a hybrid between common stock and debt instruments, blending properties of each – for example, preferred shares hold priority claim over common shareholders yet have no voting rights and receive fixed dividend payments similar to interest expense payments.
  3. Debt: Capital borrowed from lenders with the company acting as a borrower – which is agreed upon in exchange for scheduled interest expense payments throughout the term of the debt as well as the full repayment of the original principal amount on the date of maturity.

Of the various benefits of using debt capital, one notable advantage is related to interest expense being tax-deductible (i.e. the “tax shield”), which lowers the taxable income of a company and the amount in taxes paid.

Considering how debt is placed higher in the capital structure and receives priority treatment over both preferred and common shareholders, the cost of debt tends to be lower relative to the cost of equity, which is placed at the very bottom of the capital structure.

However, the use of debt financing comes with significant risks, and any company should be aware of the potential consequences of leverage, namely the increased volatility in earnings (i.e. EPS) and the potential for defaulting on debt obligations.

Note the use of leverage is neither inherently good nor bad – instead, the issue is “excess” debt, in which the negative effects of debt financing become very apparent.

Balance Sheet Leverage Ratios

On the balance sheet, leverage ratios are used to measure the amount of reliance a company has on creditors to fund its operation. The financial leverage of a company is the proportion of debt in the capital structure of a company as opposed to equity.

Here, the questions answered are, “What is the current mixture of debt and equity in the company’s capital structure, and is the D/E ratio sustainable?”

For a company dependent on creditors (e.g. to purchase inventory or fund capital expenditures), the unexpected cut-off in access to external financing could be detrimental to the ability of the company to continue operating.

  • High Leverage: Significant reliance on external debt financing sources
  • Low Leverage: Operations are funded mostly with internally generated cash (i.e. retained earnings)

In general, increased amounts of leverage in the capital structure equates to more financial risk, since the company incurs greater interest expense and mandatory debt amortization as well as principal repayments coming up in the future.

But if a company opts to use very minimal leverage, the downside is that there are more shareholders with claims to the same amount of net profits, which results in fewer returns for all equity holders – all else being equal.

Not to mention, the company is unable to benefit from the reduced taxes associated with the tax-deductibility of interest expense, or the lower cost of capital (i.e. debt is a cheaper source of capital than equity, up to a certain point).

Leverage Ratio Purpose Formula
Debt-to-Assets Ratio
  • The debt-to-assets ratio compares a company’s total debt to its assets, with a higher value meaning that the company has purchased the majority of its assets using debt.
  • Debt-to-Assets Ratio = Total Debt / Total Assets
Debt-to-Equity Ratio (D/E)
  • The debt-to-equity ratio compares a company’s debt to the shareholders’ equity, with a high ratio suggesting the company’s operations have been financed with more debt.
  • Debt-to-Equity Ratio (D/E) = Total Debt / Total Equity
Debt-to-Total Capitalization
  • The debt-to-capital ratio compares the total debt to the sum of all capital sources, with the purpose of measuring the percentage of the total capital structure attributable to debt.
  • Debt-to-Total Capitalization = Total Debt / (Debt + Equity + Minority Interest + Preferred Stock)
Net Debt-to-Total Capitalization

 

  • The inherent assumption in the net debt-to-capital ratio is that the cash on the B/S can be used to help pay down existing debt – thus the total debt amount is adjusted to account for the available cash balance.
  • Net Debt-to-Capital = (Total Debt – Cash) / (Debt + Equity + Minority Interest + Preferred Stock – Cash)
Balance Sheet Leverage Ratios Example

Let’s say there’s a company with the following balance sheet data:

  • Total Assets = $70 million
  • Total Debt = $30 million
  • Total Equity = $40 million

To calculate the B/S leverage ratios, we’d use the following formulas:

  • Debt-to-Equity = $30 million ÷ $40 million = 0.8x
  • Debt-to-Assets = $30 million ÷ $70 million = 0.4x
  • Debt-to-Total Capitalization = $30 million ÷ ($30 million + $40 million) = 0.4x

BS EX

Cash Flow Leverage Ratios

An alternative approach is to measure financial risk using cash flow leverage ratios, which help determine if a company’s debt burden is manageable given its fundamentals (i.e. ability to generate cash).

In practice, leverage ratios measure the proportion of a company’s debt amount to another financing metric (e.g. equity, asset, total capitalization) or to a cash-flow metric to see if the company’s FCF generation could support payments on debt, most notably:

  • Interest Expense Payments
  • Required Debt Amortization
  • Full Principal Repayments on Date of Maturity

The more predictable the cash flows of the company and consistent its historical profitability has been, the greater its debt capacity and tolerance for a higher debt-to-equity mix.

Cash flow leverage ratios are arguably a more practical approach in thinking about the financial risk of a company, since you’re comparing two off-setting factors:

  1. “How much does the company owe?”
  2. “How much cash flow does the company generate?”

The purpose of cash flow leverage ratios is to assess if the company’s cash flows can adequately handle existing debt obligations.

If yes, the company’s debt-related payments such as interest expense and principal repayment are supported by its cash flows and payments can be met on schedule.

The most common cash flow leverage ratio used by lenders and in credit analysts is the total leverage ratio (i.e. total debt-to-EBITDA), but there are numerous other variations.

Leverage Ratio Purpose Formula
Total Debt-to-EBITDA
  • The number of years required for the entire debt balance to be paid off at the current level of EBITDA
Total Debt / EBITDA
Net Debt-to-EBITDA
  • The number of years required for the debt balance, net of existing cash on the B/S, to be paid off at the current level of EBITDA
Net Debt / EBITDA
Total Debt-to-EBIT
  • The number of years required for the entire debt balance to be paid off at the current level of operating income (EBIT)
Total Debt / EBIT
Total Debt-to-EBITDA Less CapEx
  • The number of years required for the total debt balance to be paid off at the current level of EBITDA, once CapEx is deducted – i.e. the more conservative approach
Total Debt / (EBITDA – CapEx)

Each of these measures, regardless of the cash flow metric chosen, shows the number of years of operating earnings that would be required to clear out all existing debt.

In effect, cash flow leverage ratios provide more insights into the ability of the company’s cash flows to cover upcoming debt obligations, as opposed to a proportion of how levered a particular company’s capital structure is.

Note that if you ever hear someone refer to the “leverage ratio” without any further context, it is safe to assume that they are talking about the debt-to-EBITDA ratio.

Leverage Ratio Formula

Here, EBITDA is used as a proxy for operating cash flow and the question being answered is: “Is the company’s cash flow generation capacity enough to satisfy its outstanding financial obligations?”

EBITDA is the most widely used proxy for operating cash flow, despite its shortcomings, such as ignoring the full cash impact of capital expenditures (CapEx).

For highly cyclical, capital-intensive industries in which EBITDA fluctuates significantly due to inconsistent CapEx spending patterns, using (EBITDA – CapEx) can be more appropriate.

The senior debt leverage ratio is important to track because senior lenders are more likely to place covenants – albeit, such restrictions have loosened across the past decade (i.e. “covenant-lite” loans).

For the net debt leverage ratio, many view it as a more accurate measure of financial risk since it accounts for the cash sitting on the B/S of the borrower – which reduces the risk to the lender(s).

Each of the acceptable ranges for the listed leverage ratios is contingent on the industry and characteristics of the specific business, as well as the prevailing sentiment in the credit markets.

Default Risk

The default risk is a sub-set of credit risk that refers to the risk that the borrower might default on (i.e. fail to repay) its debt obligations.

An excessive reliance on debt financing could lead to a potential default and eventual bankruptcy in the worst-case scenario.

Often, a company will raise debt capital when it is well-off financially and operations appear stable, but downturns in the economy and unexpected events can quickly turn the company’s trajectory around.

Sometimes the best course of action could be to potentially hire a restructuring advisory firm in anticipation of a missed interest payment (i.e. default on debt) and/or breached debt covenant.

From a restructuring standpoint, the earlier the company can get in front of the problem without involving the Bankruptcy Court, the better off the company is likely going to be.

Leverage Ratios vs Coverage Ratios

Leverage ratios set a ceiling on the debt levels of a company, whereas coverage ratios set a minimum floor that the company’s cash flow cannot fall below.

For the most part, higher leverage ratios often indicate that the company has raised debt capital near its full debt capacity or beyond the amount it could reasonably handle.

Unlike coverage ratios, lower leverage ratios are viewed as a positive sign in terms of financial health.

For example, the higher the times interest earned ratio (TIE), the better off the company is, because a higher ratio means the company can pay off its interest expense multiple times using the cash flows it generates.

In contrast, higher leverage ratios relative to comparable peers could be concerning, especially if the ratio has been trending upward in recent periods, as the two potential drivers are:

  1. The proxy for operating cash flow, EBITDA, has been declining.
  2. The amount of total debt outstanding has remained constant (or potentially increased).

From the perspective of lenders, a higher ratio of debt relative to its cash flow, assets, or equity indicates the company chose to take on a large amount of debt, thereby increasing the likelihood that they could fail to service a debt payment on time due to lack of liquidity or cash flows.

Leverage Ratios in Covenants

In loan agreements and other lending documents, leverage ratios are one method for lenders to control risk and ensure the borrower does not take any high-risk action that places its capital at risk.

For instance, lenders could set maximum limits for total leverage ratios within their credit agreements.

If the borrower breaches the agreement and the leverage ratio exceeds the agreed-upon ceiling, the contract could treat that as a technical default, resulting in a monetary fine and/or the immediate repayment of the full original principal.

In particular, senior lenders, such as corporate banks, tend to be more strict when negotiating lending terms with regards to the requirements that the borrower must abide by.

Cash Flow Leverage Covenants

There are two main types of debt covenants, with the first being “maintenance” covenants.

Maintenance covenants are defined as contractual agreements requiring the borrower to maintain compliance with certain credit metrics, with periodic testing performed at the end of each quarter.

Oftentimes, the maintenance covenants are cash flow leverage ratios, as shown by the examples below.

  • Total Debt-to-EBITDA cannot exceed 6.0x
  • Senior Debt-to-EBITDA cannot exceed 3.0x

Lenders often also place restrictions meant to impede certain actions such as issuing dividends to shareholders or raising more debt beyond a certain level.

For so-called “incurrence” covenants, testing is done once “triggering events” occur to confirm that the borrower still complies with lending terms – e.g. issuing additional debt, debt-funded M&A, cash dividends to shareholders, share repurchases, etc.

Leverage Ratio Excel Template

Now that we’ve discussed the concept of cash flow leverage ratios as well as the most common examples of each, we can now move on to applying those concepts into practice.

For access to the model template, fill out the form below:

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Leverage Ratio Model Assumptions

In the first section of our leverage ratio modeling exercise, we’ll start by providing the model assumptions.

Here, we’ll be assessing two different operating scenarios:

  1. “Upside” Case
  2. “Downside” Case

For either case, the starting point will be 2021, from which we’ll be adding the balance to the step function for the applicable line items.

2021 Income Statement Financials
  • Revenue: $125m
  • EBITDA: 40% Margin → $50m
  • EBIT: 30% Margin → $38m

Next, we’ll state the assumptions regarding the year-over-year (YoY) changes for both the “Downside” and the “Upside” cases.

Income Statement Assumptions

Upside Case – Step Function

  • Revenue % Growth: +1.0%
  • EBITDA % Margin: +2.5%
  • EBIT % Margin: +2.0%

Downside Case – Step Function

  • Revenue % Growth: –2.0%
  • EBITDA % Margin: –2.5%
  • EBIT % Margin: –2.0%

As for the capitalization section, we only require two metrics:

  1. Cash & Equivalents: Cash and highly liquid assets (e.g. marketable securities)
  2. Total Debt: Both long-term and short-term debt, as well as any interest-bearing instruments

And from those two metrics, we can calculate the net debt balance by subtracting the cash balance from the total debt outstanding.

In 2021, our company has $50m in “Cash & Equivalents” and $200m in “Total Debt”, which is comprised of $150m in “Senior Debt” and $50m in “Subordinated Debt”.

Balance Sheet Assumptions

Upside Case – Step Function

  • Cash & Equivalents: +$5m
  • Senior Debt: –$10m
  • Subordinated Debt: –$5m

Downside Case – Step Function

  • Cash & Equivalents: –$10m
  • Senior Debt: –$5m
  • Subordinated Debt: –$2m

In the “Upside” case, the company is generating more revenue at higher margins, which results in greater cash retention on the balance sheet.

The increase in free cash flow (FCF) also means more discretionary debt can be paid down (i.e. optional prepayment), which is why the debt repayment is greater relative to the other case.

Conversely, in the “Downside Case, the company’s revenue is growing at a negative rate with lower margins, which causes the cash balance of the company to decline.

The debt repayment is lower in the second scenario, as only the mandatory amortization payments are made, as the company does not have the cash flow available for the optional paydown of debt.

Leverage Ratio Example Calculation

Now, we have all the required inputs for our model to calculate three important leverage ratios using the following formulas.

  • Total Debt-to-EBITDA: Total Debt ÷ EBITDA
  • Senior Debt-to-EBITDA: Senior Debt ÷ EBITDA
  • Net Debt-to-EBITDA: Net Debt Debt ÷ EBITDA

Under the “Upside” case, our total leverage ratio declines in half from 4.0x to 2.0x from 2021 to 2025, which is attributable to the increased free cash flow (FCF) generation, higher profit margins, and greater cash balance.

The senior leverage ratio is also reduced by half from 3.0x to 1.5x – which is caused by the increased discretionary paydown of the debt principal (i.e. –$10m each year).

In the same time horizon, the net debt leverage ratio falls from 3.0x to 1.0x, with the most significant contributor being the total accumulation of cash.

Leverage Ratio – Upside

In the final section of our model exercise, we’ll perform the same calculations but under the “Downside” scenario.

As expected, each of the leverage ratios increases as a result of the sub-par performance of the company.

From 2021 to the end of 2025, the total leverage ratio increases from 4.0x to 4.8x, the senior leverage ratio increases from 3.0x to 3.6x, and the net debt leverage ratio increases from 3.0x to 4.5x.

By the end of Year 5, the net debt-to-EBITDA ratio is marginally lower than the total debt-to-EBITDA ratio due to the diminished cash balance.

In this case, the company’s senior lenders would likely become concerned regarding the borrower’s default risk, since the senior leverage ratio exceeds 3.0x – which is on the higher end of their typical lending parameters.

Leverage Ratio – Downside

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