Leverage Ratio - Explained
What is a Leverage Ratio?
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Table of ContentsWhat is a Leverage Ratio?How Does a Leverage Ratio Work? Leverage Ratios and BanksThe Consumer Leverage RatioThe Debt-to-Capital RatioAcademic Research on Leverage Ratio
What is a Leverage Ratio?
A leverage ratio refers to a type of financial metric that is used to check the amount of capital coming in the form of debt, such as loans. In other words, it is a tool that the companies use to assess their ability to meet financial obligations. This financial tool is important because most firms depend on a combination of debt and equity to finance their operations. So, leverage ratio is an essential instrument when a company wants to evaluate its ability to settle debt any time they are due.
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How Does a Leverage Ratio Work?
Most businesses depend on funds from financial institutions and investors to expand their operations. However, it is important to note that too much debt can be harmful. A controlled debt helps a company to generate earnings. Also, for a firm to make profits, its returns on capital must be more than the interest rate it pays on debts and loans. Also, uncontrolled debt can reduce the company's credit rating. On the other hand, a company with few debts may also be questionable. Note that some investors may see a lack of borrowing as a sign that the operating mechanism is tight. So, the leverage ratio ensures that there is a perfect balance between capital structure and cost of capital. A company can also make use of leverage ratios to measure a business's mix of operating expenses. By doing so, it is able to know how changes in output affect operating income. Operating costs are of two types: variable and fixed costs. However, the mix is likely to differ depending on the industry and company.
Leverage Ratios and Banks
Most leveraged institutions in the U.S. are banks. A combination of Federal Deposit Insurance Corporation (FDIC) and fractional-reserve banking has ensured protection creating a banking environment with less lending risks. However, the majority of leverage ratios' banking regulations are quite complicated. The Federal Reserve has come up with guidelines for those financial institutions holding companies. Nonetheless, these restrictions vary depending on the bank's assigned rates. Generally, banks that go through rapid growth or face financial difficulties are expected to maintain a high level of leverage ratios. There are various types of minimum reserve ratios and capital requirements placed on American banks through the currency's Comptroller and FDIC. These ratios have a direct impact on leverage ratios. The scrutiny applied to leverage ratios has been able to increase since the 2007-2009 Great Recession. However, there is a natural limitation that these restrictions have on the number of loans made. The reason is that it is easier for banks to borrow funds than to raise capital. So, when restrictions are not put, the rate of borrowing will go high, and this may lead to increased debt. Besides, the high capital requirement is likely to reduce the number of dividends for investors or dilute the value of shares issued. All these are not healthy for the company.
The Consumer Leverage Ratio
In the United States, economists use this type of leverage ratio to measure the average consumers debt amount relative to his or her disposable income. Following their observation, some have stated that consumers debt growth level rapid increase is the reason for the growth in corporate earnings for the past few decades. However, other economists are of the view that consumer debt high levels are the reason why the country experiences a great recession.
The Debt-to-Capital Ratio
It refers to a type of ration that measures the financial leverage of a company. It is among the many meaningful debt ratios. It focuses on the debt liabilities, which are considered to be part of a total capital base of a company. The debts are usually long-term and short-term obligations, whereas shareholders equity and the company's debt represent the capital. The debt-to-capital ratio is what companies use to evaluate its financial structure and the performance of its financial operations.
Academic Research on Leverage Ratio