What Is a Good Leverage Ratio for a Business?

Financial leverage is the use of borrowed money to finance the purchase of assets. Businesses take on debt expecting that the income or capital gain from the new asset will exceed the cost of borrowing. This strategy can magnify returns on shareholder equity and fuel growth that might not be possible using only existing capital, allowing companies to invest in new equipment, facilities, or acquisitions.

The use of leverage, however, introduces financial risk. The obligation to make regular interest and principal payments on debt creates a fixed cost for the business. While these payments are manageable during periods of strong performance, they can strain cash flow and threaten a company’s solvency in a downturn. Understanding this balance between potential returns and assumed risk is central to sound financial management.

Common Leverage Ratios and Their Formulas

A leverage ratio is a financial metric that compares a company’s debt to another financial measure, such as its assets, equity, or earnings. These calculations provide a standardized way to assess how much a company relies on borrowed funds. Common ratios include:

• Debt-to-Equity Ratio: Calculated by dividing total debt by shareholders’ equity, this ratio compares capital from creditors to capital from owners. Total debt includes all interest-bearing liabilities, both short-term and long-term. A result of 1.0 means that for every dollar of equity, the company has a dollar of debt.
• Debt-to-Assets Ratio: This ratio shows the proportion of a company’s assets financed through debt using the formula Total Debt / Total Assets. It provides insight into how a company funds its growth, as a higher ratio indicates greater reliance on borrowing to acquire assets like cash, inventory, and equipment.
• Debt-to-Capital Ratio: This measures debt against the company’s total capital base and is calculated as Total Debt / (Total Debt + Shareholders’ Equity). The ratio is useful for understanding a company’s financing structure by showing what percentage of its funding comes from debt.
• Debt-to-EBITDA Ratio: Often used by credit agencies, this ratio uses the formula Total Debt / EBITDA. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and is a proxy for operating cash flow. This ratio assesses a company’s ability to repay debt using its operational earnings.

Interpreting Leverage Ratios

A high leverage ratio signifies that a company has taken on a significant amount of debt to finance its assets. This aggressive financing can amplify returns for shareholders when the company is performing well, as profits are generated on a larger asset base than owners alone have funded. However, it also comes with increased financial risk and can make it more difficult or expensive to secure additional financing, as lenders may view the company as overextended.

Conversely, a low leverage ratio indicates a more conservative financial structure that relies more on equity financing from owners than debt from creditors. This position is considered less risky, and with lower interest expenses, the company has more financial flexibility to withstand economic downturns. The drawback is that a company with very low leverage might miss opportunities to accelerate growth, potentially leading to slower expansion compared to more leveraged competitors.

Determining an Optimal Leverage Ratio

There is no single leverage ratio that is considered “good” for all businesses. The optimal level of debt is a range that depends on the specific context of the company and its industry.

Capital-intensive industries, such as utilities, manufacturing, and telecommunications, require substantial investments in property and equipment. These companies often have stable and predictable revenue streams, which allows them to safely support higher levels of debt. It is not uncommon for a utility company to have a debt-to-equity ratio well above 1.0, as lenders are confident in their ability to service their obligations.

In contrast, industries like software development or consulting have fewer tangible assets to use as collateral for loans. Their value is more dependent on intellectual property and human capital, so a lower leverage ratio is considered prudent. A high debt level in a technology firm could be a warning sign to investors and analysts.

A company’s stability and the predictability of its cash flows are also considerations. A business with a long history of stable earnings can manage more debt than a cyclical company whose profits fluctuate. The cost of debt, influenced by prevailing interest rates, also plays a role; lower interest rates make debt financing more attractive.

Leverage Ratios in Financial Analysis

Investors, lenders, and company management use leverage ratios to gain insights relevant to their specific interests. For investors, these ratios are a tool to assess the risk-return profile of an equity investment. A company that effectively uses debt can generate higher returns on equity, but excessive leverage increases the risk of earnings volatility and potential loss.

Lenders and creditors rely on leverage ratios to evaluate a company’s creditworthiness. They use metrics like the debt-to-EBITDA ratio to determine a company’s ability to make payments on its existing debt. This analysis influences a lender’s decision to extend credit and determines the interest rate and other terms of a loan.

Company management uses leverage ratios as a guide for making strategic decisions about capital structure. By monitoring these metrics and comparing them to industry benchmarks, executives can decide whether to finance new projects with debt or equity. These ratios help management balance maximizing shareholder returns with maintaining financial stability.