Financial leverage is the amount of debt used by a company relative to the equity in its capital structure. Financial leverage is measured by means of leverage ratios, these encompassing any ratio that provides an indication of the extent to which the firm is using long-term debt, and of the long-term solvency of the firm. The book value of a firm’s debt and equity is normally used in order to calculate the ratios. The principal leverage ratios are:
- Debt/equity ratio – Measures the riskiness of a company’s capital structure by relating the amount of capital supplied by the firm’s creditors to the amount supplied by the firm’s owners:
Total Liabilities ÷ Total Shareholders’ Equity
Funded Debt ÷ Total Shareholders’ Equity
- Debt ratio – The leverage ratio that measures the proportion of all tangible assets that are financed with debt:
- Fixed assets-to-equity capital ratio – Shows the proportion of a firm’s fixed assets (i.e., property, plant and equipment) financed by owners’ equity:
PP&E ÷ Total Shareholders’ Equity
- Total debt to EBITDA ratio – The leverage ratio of all of a firm’s debt to income before interest taxes, depreciation, amortization (EBITA), and other noncash charges:
Total Liabilities ÷ EBITA
Funded Debt ÷ EBITA
Total Debt ÷ EBITA
Investments in fixed assets are essential for long-term solvency. Capital-intensive industries tend to have high levels of debt to finance their property, plant and equipment. however, industry factors play an important role both in the level of debt and its nature.
If a firm’s net worth increases while its leverage ratios decrease, it is becoming less dependent on debt and is investing more of its own resources to generate assets.