If you're running a startup, odds are that you might be trying to secure funding: from friends and family, from a venture capital firm, from crowdfunding, or from a bank.
If you're trying to secure funding, it's important to have your financial records in order so investors can evaluate if your business would make a risky or worthwhile investment. One of the metrics they might use to judge the health of your business? Your financial leverage, which can be measured quantitatively with financial leverage ratios. In this post, we'll explain financial leverage ratio, and how to calculate the most common ratios you need to know.
Financial Leverage Ratio
Financial leverage ratios, or gearing ratios, comprise a category of ratios that evaluate the financial leverage a business in terms of its assets, liabilities, and equity. These ratios evaluate how much a business' capital comes from debt, which indicates how risky or not a business is from the perspective of its use of debt relative to its assets and equity.
A higher financial leverage ratio indicates that a company is using debt to finance its assets and operations, versus a company with a lower financial leverage ratio, which indicates that, even if the company does have debt, its operations and sales are generating enough revenue to grow its assets through profits.
Generally speaking, businesses aim for these ratios to fall between 0.1 and 1.0, with a ratio of 0.1 indicating that a business almost no debt relative to equity, and a ratio of 1.0 indicating that a business has as much debt as it has equity. A ratio of 0.5 is common -- indicating that a business has 2X as many assets as it has liabilities -- and higher ratios are common among startups just starting out, or businesses with high production costs.
How to Calculate Leverage Ratio
There are a few different types of leverage ratios that fall under the financial leverage ratio umbrella. Here's how to calculate three of them, using data found on your balance sheet or general ledger:
Operating Leverage Ratio
Operating leverage ratio measures the ratio of a business' contribution margin to its net operating income. It evaluates how much a business' income changes relative to changes in sales. It's calculated using the following formula:
Operating Leverage Ratio = % change in EBIT (earnings before interest and taxes) / % change in sales
Net Leverage Ratio
Net leverage ratio, or net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) measures the ratio of a business' debt to earnings. It reflects how long it would take a business to pay back its debt if debt and EBITDA were constant. It's calculated using the following formula:
Net Leverage Ratio = (Net Debt - Cash Holdings) / EBITDA
Debt to Equity Ratio
Debt to equity ratio measures the ratio of a business' total liabilities to its stockholders' equity. It offers an at-a-glance look at the value of a business relative to its debts. It's calculated using the following formula:
Debt to Equity Ratio = Liabilities / Stockholders' Equity
This ratio can vary depending on the industry and products or services sold. For example, General Motors had a debt to equity ratio of 5.03 in the 2017 fiscal year, which is a reflecting of the high costs of establishing, staffing, and running vehicle manufacturing operations around the world.
To learn more, read about how to identify your business' niche market next.
Originally published Nov 2, 2018 8:30:00 AM, updated April 29 2019