Having a lot of assets in various forms both cash, securities, vehicles, property, etc. visibly shows success in achieving financial independence. Though not always the case. Most people judge the success of others financially only from the outside, without delving into them.
A person’s financial success is not only seen from the amount of assets, but also the amount of debt he has. If the amount of debt is far greater than the amount of its assets, then every individual or legal entity cannot be said to be financially successful. Many instruments are used to assess whether or not the financial foundation of a person or company is strong. One of them is the leverage ratio .
Definition of leverage ratio
Leverage ratio or more familiarly called the leverage ratio is a financial ratio that shows the level of debt that has been issued by a business entity or business. The leverage ratio is also called the solvency ratio can be understood as a financial ratio that measures the ability of a company to meet its obligations or long-term debt. Long-term debt itself is interpreted as an obligation or debt with a maturity of more than one year.
The leverage ratio compares the total debt burden of a company against its assets or equity. That is, this ratio shows how much company assets owned by shareholders compared to assets owned by creditors or lenders. A company is said to have a high level of leverage, if the number of assets owned by the company is less than the total assets of its creditors.
As one of the parameters to measure the financial health of a company, leverage ratios are needed to help management and investors understand the level of capital structure in related companies. In addition, this ratio also reflects sources of financing in business operations or business activities of the company, from debt or equity.
The leverage ratio function
In general, the leverage ratio serves to measure the company’s ability to meet its financial obligations both in the short and long term. This ratio is also used to determine the composition of capital sourced from debt or loans. In analyzing company finances, leverage ratio has an important role. Therefore, this ratio can inform the source of funds used to finance the company’s operations or business activities, from own capital or debt. In addition, the company can also evaluate its ability to repay its debts when due.
The leverage ratio describes the composition of the capital structure used to finance the company’s operations. A company that has a high leverage ratio in its capital structure can be risky, but on the other hand it can also provide benefits.
The use of debt in business operations can be profitable, if the company is able to generate profits. Conversely, companies with high leverage will actually experience a higher default risk against financial obligations if their profitability decreases, compared to companies that lack leverage.
Leverage ratios are important for analyzing the level of debt a company has. This ratio not only provides benefits internally, namely company management but also external parties, namely investors and creditors. For company management, the leverage ratio is used to evaluate the company’s performance in generating profits that are used to pay debts both in the short and long term. The leverage ratio for investors is useful in further analyzing the company’s finances before deciding to invest in related companies. While for creditors, the leverage ratio is used as a consideration in decision making related to lending.
Types of leverage ratios
The leverage ratio has quite a variety of types. From the types of leverage ratios are used as a basis or material consideration by market analysts, investors, and creditors. The following types of leverage ratios are commonly used to measure a company’s ability to pay long-term obligations.
- Debt to asset ratio (Debt-to-Assets Ratio)
Debt to asset ratios are often referred to simply as debt ratios. This ratio is used to measure the ability of companies to rely on debt to finance their assets. This ratio calculation is done by dividing the total debt with the total assets owned by the company, formulated as follows.
Debt ratio = Total debt / Total assets
- Debt to equity ratio (Debt-to-Equity Ratio)
Debt to equity ratio is a financial ratio that is a relative proportion between debt and equity used to finance company assets. To calculate this ratio, total debt obligations are divided by total equity. The formula for this ratio is as follows.
Debt to equity ratio = Total debt / Total equity
- Debt to capital ratio (Debt-to-Capital Ratio)
Debt to capital ratio is one debt ratio that focuses on debt obligations as a component of the company’s total capital base. Debt includes all obligations both short and long term. While capital includes corporate debt and shareholder equity.
The benefit of the debt to capital ratio is to evaluate the company’s capital or financial structure and its use in financing the company’s business operations. If the debt to capital ratio in one company is high compared to other companies, the risk of default faced by the company is also high as the impact of debt on business operations. This ratio calculation is done by dividing total debt by total debt after adding up the total equity. The following formula formulation.
Debt to capital ratio = Total current debt / (Total debt + Total equity)
- Debt to gross profit ratio (Debt-to-EBITDA Ratio)
EBITDA is an acronym for Earning Before Interest, Taxes , Depreciation , and Amortizationi.e. income earned before deducting interest expenses, taxes, depreciation, and amortization, or in short is gross profit. This debt to gross profit ratio is used to measure a company’s ability to pay off debt. This ratio is also used to determine the probability of default risk against debt. If this ratio reaches more than 3, it means that the company’s ability to meet its debt obligations is quite alarming. In other words, the risk of default is quite high. Therefore, the total debt obligations that must be paid by the company are far greater than the achievement of profitability. This ratio calculation is done by dividing the total debt with gross profit. The following formula.
Debt to Gross Profit Ratio = Total Debt / Gross Profit
The higher the leverage ratio, the higher the risk of default on debt obligations faced by the company. However, the high leverage ratio can have a positive impact on the sustainability of the company’s business operations, if supported by the achievement of high profitability as well.