What is the leverage ratio?
Debt is thought of as generally undesirable—even if it’s generally unavoidable. But the truth is that most of us are dealing with some kind of debt. We have credit card debt. We owe our buddy $20 for beers the other night. The more adult-y among us have a mortgage, or perhaps took out a personal loan at some point. But another way to look at it is: Debt provides: A house. Some clothes. A few beers. It works the same for companies, too. Debt is a crucial part of doing business.
But when you’re looking to invest in a company: How much debt is too much debt?
A high level of debt means a higher risk of defaulting, so it’s important that investors have the ability to judge what a company’s debt could indicate about its future. And the best way to evaluate that is by calculating the company’s leverage ratio, which evaluates debt levels in relation to assets. By determining a company’s leverage ratio, you’re able to determine how efficiently a company is able to meet its financial obligations—or whether it’s likely to be saddled down by debt in the future. When a company has a large amount of debt, it’s more susceptible to economic downturns, more unlikely to make regular interest payments, and in danger of ceasing operations altogether, costing investors money and pain.
However, just like in personal finance, not all debt is bad. All companies will have some kind of debt; after all, a company finances itself through a combo of its own money (equity) and debt, which is referred to as leveraging. The key is just finding out what that ratio—aka the leverage ratio—is.
Financial leverage ratio formula
The most popular leverage ratio formula is the debt-to-equity ratio:
Debt-to-equity ratio: total debt / total equity
How to calculate leverage ratio formula
So let’s say a company has $8 million in debt and $14 million in equity. That means that their debt-to-equity ratio is: 8 million/14 million, which is 0.57, or 57%. So that means that to every dollar of assets this company has, it has $0.57 of debt. If the ratio were above 1.0, that means that the company has more debt than assets, which—we’re sure we don’t need to tell you—is less than ideal.
This information shows you exactly how much of a company’s equity belongs to shareholders, and how many of its assets belong to creditors. If the debt to equity ratio is low, that means that shareholders own most of the assets, which means that the company is less leveraged. If the ratio is high and creditors own most of the assets, and the company is said to be highly leveraged. As an investor, having this information will help you assess the risk of an investment and how the company is handling its business.
This formula also holds for any type of situation where you’re trying to evaluate how much liability, or total debt, a company is carrying in general. The basics of the ratio will always be:
Debt ratio: total debt / total assets
So you’re always comparing the amount of total debt (liability) a company has to how much it actually possesses , whether that be through assets or equity, and whether its current debt situation is sustainable (aka whether this is a place you want to be putting your money into). When considering just the debt ratio, you’ll want a figure under 0.5 (since assets include equity plus debt, so it’ll be half of the debt-to-equity ratio).
However, analysts warn that too low of a ratio isn’t desirable either, since it’s a sign that the business is relying too heavily on equity to sustain itself, which is probably going to be pretty unsustainable in the long run. As with all things, you’ll want a nice balance.
What is the consumer leverage ratio
The term began gaining traction after the Harvard Business Review wrote a post mortem of sorts after the 2008 financial crash and evaluated how consumer debt could affect the economy. Basically, the consumer leverage ratio (also known as the debt-to-income ratio) looks at total household debt (which includes your consumer debt and mortgage loans) in relation to personal disposable income. The ratio looks at how much of your money is tied up in debt, and how much money you have at your disposal to pay off that debt. So the basic formula would be:
Consumer leverage ratio: total household debt / disposable personal income
So if you have a credit card bill of $10,000 but only have $7,000 in your checking account and savings combined, your ratio is looking pretty high (in this case, it would be 1.43). In this case, this number demonstrates how many years it would take on average to pay off the debt in full, if the whole annual disposable income were used to do so. This is assuming that the income is spent on nothing other than paying off debt, which is of course ridiculous.
We probably don’t need to tell you that a high ratio is not good news for anyone involved, including the economy. Many consumer goods are bought on credit, and if disposable income isn’t sufficient to pay off the debt accrued, then businesses that sold goods on credit are in trouble as well.
This is why we often advise tackling high-interest debt before making any investing moves. When talking about what we like to call the “financial hierarchy of needs,” the foundation begins with good credit, an emergency fund, and some sort of steps taken toward retirement. High-interest debt is particularly dangerous here, because it can quickly accumulate and eat at you even if you pay off bits at a time.
Consumer leverage ratio also becomes important when you want to take out a bigger loan, such as a mortgage. A smaller ratio will indicate to lenders that you’re managing smaller monthly debt payments and are probably on top of your debt. A larger ratio, on the other hand, may suggest that your income is not keeping up with your debt.
How to lower your ratio
In order to qualify for loans such as mortgages, your debt-to-income ratio can be no higher than 43%, although it’s of course advisable to keep that number much lower. Let’s say you have a monthly debt of $1,500, which comes from mortgage payments and credit card debt. Your monthly income is $4,000, your ratio would be 0.38, or 38%. That’s not terrible, but it could be better. So how can you lower your ratio? The good, painful, old-fashioned way: saving more and spending less.
There are plenty of great tricks to help you develop saving habits that are as painless as possible, including setting up automatic deposits into a savings account (preferably one with high-yield rates and minimum account sizes), cutting down on subscriptions, and paying for most of your daily expenses in cash. A lot of efficient saving strategies simply require you to make some small changes to your routine, such as cooking more at home rather than eating out or investing in a reusable water bottle to stop buying bottled water. Another great saving tip? Using an app that’ll round up your spare change and automatically save it or place it in an investment account.
The end goal of all this is that by achieving a lower consumer leverage ratio, you’ll not only qualify for certain benefits such as qualified mortgages (and a calmer state of mind from not having a mountain of debt weighing you down), you’ll also build the financial foundation to start investing. By getting your financial picture in order, you’ll be able to start putting money away toward future goals—just like a company does.
Are you wondering whether you’re ready to start investing yet? At Wealthsimple, we can help you set up a high-interest savings account to start building up a financial foundation, as well as helping you take the first steps toward investing. We’ll guide you through every step of the way with personalized portfolios tailored to your financial goals and risk tolerance, as well as expert financial advice. Get started today.