Leverage ratio (Debt ratio)

Financial sustainability is an integral part of the overall sustainability of the enterprise, the balance of financial flows, the availability of funds that allow the organization to maintain its activities for a certain period of time, including servicing the loans received and producing products.

The economic meaning of the ratio of borrowed and own funds consists in determining how many units of borrowed financial resources there are per unit of sources of own funds.

The recommended value of the coefficient is less than 1. The lower the value of the indicator, the higher the financial stability and independence of the enterprise from borrowed capital and liabilities.

The level of this ratio above 1 indicates the potential risk of a shortage of own funds, which may cause difficulties in obtaining new loans.

Definition

The ratio of financial leverage (debt-to-equity ratio) is an indicator of the ratio of borrowed and own capital of an organization. He belongs to the group of the most important indicators of the financial situation of the company, which includes coefficients of autonomy and financial dependence that are similar in meaning, also reflecting the proportion between the organization’s own and borrowed funds. The term “financial leverage” is often used in a more general sense, speaking of a principled approach to financing a business, when with the help of borrowed funds an enterprise forms a financial lever to increase the return on its own funds invested in a business.

Calculation (formula)

The ratio of financial leverage is calculated as the ratio of borrowed capital to equity:

Financial Leverage Ratio = Liabilities / Equity

Both the numerator and the denominator are taken from the liabilities side of the organization’s balance sheet. Liabilities include both long-term and short-term liabilities (i.e., all that remains of the deduction from the balance sheet of the equity balance).

Normal value

The optimal ratio, especially in Russian practice, is an equal ratio of liabilities and equity (net assets), i.e. financial leverage ratio equal to 1. The value of up to 2 may also be acceptable (for large public companies this ratio may be even greater). At large values ​​of the coefficient, the organization loses its financial independence, and its financial position becomes extremely unstable. It is more difficult for such organizations to attract additional loans. The most common ratio in developed economies is 1.5 (ie, 60% of borrowed capital and 40% of its own).

Too low value of the financial leverage ratio indicates a missed opportunity to use financial leverage – to increase the profitability of equity capital by involving borrowed funds in the activity.

Like other similar coefficients characterizing the capital structure (autonomy ratio, financial dependence ratio), the normal value of the financial leverage ratio depends on the industry, enterprise scale and even the way of organizing production (capital-intensive or labor-intensive production). Therefore, it should be evaluated in dynamics and compared with the indicator of similar enterprises.