Having more debt than operating cash flow and equity can make it difficult for a small business to make ends meet. Paying bills and employee salaries, purchasing inventory and supplies, and covering the costs of daily business expenses would be challenging. Moreover, a business that carries a high amount of debt might end up borrowing money to stay afloat, which leads to even more debt. When a business has excessive debt and cannot repay what it borrowed or pay its operating expenses, it is overleveraged. A leverage ratio is a helpful metric for measuring a business’s overall debt in relation to its cash and equity.
Banks and investors use it to determine how easy it is for a company to meet its myriad financial obligations. In addition, small business owners also use this ratio to gain insight into their company’s financial position, specifically related to their level of debt. But what is a leverage ratio? In this Balboa Capital blog post, we answer that question and explain how to calculate it and interpret the results.
Leverage ratio defined.
As mentioned earlier in this blog post, a leverage ratio helps assess the level of debt that a small business has incurred. The higher the leverage, the more debt a company has, and therefore the greater risk that it will not be able to repay its debts. Conversely, if a business’s leverage ratio is low, it has more equity than debt, which means that it is less likely to default on payments. Leverage ratios also impact a company’s borrowing ability. For example, businesses with lower ratios have an easier time securing loans and other forms of financing and with more favorable terms.
Leverage is created over time when business owners make investments in things like equipment, software, and vehicles, and they use either debt or equity to fund the purchase. Using debt or equity is often easier for many business owners than making a one-time cash purchase. The only caveat is they need to repay the amount of money they borrow and make the payments on time. Skipping payments can result in penalties, late fees, and interest charges, increasing debt. It is also worth noting that defaulting on loan payments can hurt a credit score.
Other examples of how leverage is created.
Taking out a business loan or a line of credit, financing a fixed asset, or making purchases with a business credit card are the most common ways for small businesses to create leverage. However, there is another situation that can create leverage. A leveraged buyout may occur if a company, equity firm, or individual wants to purchase a business outright without providing a significant amount of capital. With a leveraged buyout, the buyer will use a sizeable amount of borrowed money to facilitate the transaction.
Financial leverage is a small business’s ability to generate a higher return on investment (ROI) and profit and reduce its overall expenses by paying fewer taxes. So, if a company uses debt funds with fixed charges in the form of interest, it has financial leverage. It is essential for business owners to monitor and manage their financial leverage regularly. That is because an increase in financial leverage also increases interest expenses. And higher interest expenses can reduce a company’s net income and cause a cash shortfall.
This type of leverage is unique because it doesn’t involve the amount of money a business borrowed. Instead, it is attributed to a business’s ratio of fixed costs (e.g., rent, loan payments, insurance, and taxes) to variable costs (payroll, supplies, and materials). Let us use a construction company as an example. The company has 100 employees, 15 pieces of heavy equipment financed, and an industrial office situated on 10 acres. Because the company has substantial ongoing expenses, it also has high operating leverage. A sudden dip in the number of new construction starts or an economic downturn could present the construction company with financial concerns because its fixed costs are so high.
Businesses that rely more on labor than capital-intensive assets typically have fewer fixed costs. As a result, they have a better chance of making it through times of economic uncertainty. Labor-focused businesses include accounting firms, financing companies, restaurants, and retail shops.
How to calculate leverage ratio.
There are a few different leverage ratio formulas to consider, and each one of them is straightforward. You can calculate your company’s debt to assets, equity, capital, and earnings before interest, taxes, depreciation, and amortization (EBITDA). Here are the formulas for each:
Total Debt ÷ Total Assets
Total Debt ÷ Total Equity
Today Debt ÷ (Total Debt + Total Equity)
Total Debt ÷ Earnings Before Interest Taxes Depreciation & Amortization
To illustrate how these formulas work, we’ll use a long-established winery with $10 million worth of assets, $2 million of debt, $5 million of equity, and $1 million of EBITDA each year.
$2,000,000 ÷ $10,000,000 = 0.20
$2,000,000 ÷ $5,000,000 = 0.40
$2,000,000 ÷ $7,000,000 = 0.28
$2,000,000 ÷ $1,000,000 = 2.00
Interpreting the results.
Most financial experts, business analysts, and accountants agree that a financial leverage ratio of less than 1 is something to strive for and that a ratio higher than 1 might be deemed risky by banks, business lenders, and investors. Lastly, a leverage ratio of 2 or higher is a big warning sign because it reveals a substantial amount of debt that could impede business growth, reduce or eliminate borrowing power and put a company’s survival at risk.
Companies can use their leverage ratios for better decision-making by understanding whether they are in good standing. They can also use it to indicate how well they are doing financially.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.