Leverage Ratio: Types, Formulas, Examples, and Risks

It turns out that in the world of finance and investment there are many terms that you must know, especially for those of you who are starting a business. One of the terms that may still be foreign to the ear is leverage ratio.

What is it actually leverage ratio and its function in finance? Come on, see the summary and explanationright now!

What is that leverage ratios?

Leverage ratiosis one of the ratios in accounting or finance, usually this ratio is used to measure the ability of a company or industry in terms of obligations to pay off its debts, both long-term or short-term debt.

So, it is often associated with debt or loans.

According to Fabozzi & Drake (2009), leverage ratio is a type of financial ratio to assess how much financial risk the company has taken.

In general, leverage ratio is a representation or value of the debt of a company or business that is running.

Not only displays the level of debt, leverage ratio can also show the amount of assets owned by the company. Companies that have leverage A high level company usually has a number of creditors' assets more than its total assets. 

Placement leverage ratio in a business is important, because with leverage ratios, investors can see and understand the capital structure they will invest.

Function leverage ratio

Besides being useful for investors to understand the company's capital structure, leverage ratio also has other functions, quoted from the following sources:

1. Leverage ratios will serve to assess the financial ability of a company in the long or short term. Leverage ratios it can be useful to see elements that come from debt or loans.
2. Not only looking at debts and loans as mentioned above, leverage ratio can also be used to see the movement of capital used by a company.
3. By being able to do tracking capital, debt, and loans, leverage ratio able to provide analysis related to company finances to pay off debts.
4. In corporate finance, leverage ratio useful as material for evaluating financial performance which can later be used as a benchmark for investors to make funding or decide.
5. Apart from investors, leverage ratio can also be used as a reference by creditors to consider in terms of making decisions related to loans that are usually proposed by companies to develop their business.
6. Leverage ratios can also be a measure of how much capital can be used as collateral in paying off debt.
7. The last one with leverage ratio Also the company can find out the maturity date of the debt.

Types leverage ratio

Leverage ratios There are four different types, namely:

1. Debt to EBITDA ratio

Maybe you already know what it is EBITDA which stands for Earning Before Interest, Taxes, Depreciation, and Amortization which is a measure or metric of a company's overall financial performance and is used as an alternative to net income in some financial situations.

This ratio will be used to determine the ability of a company to pay off its debts or determine whether the company has a risk of failing to pay its debts.

In this type of ratio, if the result is more than 3, it is certain that the risk in paying debt is quite high. So, the company must have an obligation to pay a fairly large debt.

The formula for the Debt to EBITDA ratio is as follows:

Debt to EBITDA = Total debt : total EBITDA

2. Debt to equity ratio

Typethe second one is debt to equity ratio or commonly abbreviated (DER) which is the ratio of debt to equity. What does debt to equity ratio mean?

Financial ratios that are relative proportions between debt and equity in the company to pay for the assets used.

Debt to equity ratio formula:

Debt to equity ratio = Total debt : total equity

3. Debt to assets ratio

As the name suggests, type This is a ratio that is often used to see the company's performance in managing debt in order to pay off the assets owned by the company.

The debt to assets ratio formula is:

Debt to assets ratio = Total debt: total assets.

4. Debt-to-capital ratio

Type the last is the debt-to-equity ratio or debt-to-capital ratio which focuses on debt as a basic component of the total firm. If a company has value debt-to-capital ratio If it is high, the risk of defaulting on debt will also be high and of course it will have an impact on the company's operational finances.

Debt to capital ratio formula:

Debt to capital ratio = Total current money : (total debt + total equity)

Example of counting leverage ratio

To understand counting leverage ratio a company, You can see an example as follows:

Company U has a total forest of IDR 10 million, total equity worth Rp. 20 million, total assets of Rp. 15 million, and the company's gross profit or EBITDA is Rp. 25 million. To calculate Company U is:

Debt to assets ratio = IDR 10 million : IDR 15 million = 0,66. This means that 0,66 or 66% of assets become debt guarantees.

Debt to equity ratio = IDR 10 million : IDR 20 million = 0,5 or 50%. 50% of the company's capital is used as collateral for debt.

Debt to capital ratio = Rp10 million : (Rp20 million + Rp10 million) = 0,333

Debt to EBITDA = IDR 10 million : IDR 25 million = 0,4.

Risks leverage ratio

In addition to having benefits or functions, leverage ratio also has a fairly risky risk for the company. There are two risksthings to note:

1. The higher the debt, the harder it will be to make a profit

As is leverage ratios, the debt level will also be higher. So it can make it difficult for the company to make a profit. The right way to avoid this is to calculatein detail and carefully, then adjusted to the needs of the company.

2. The company's psychological burden is getting higher

Having debt makes the company obliged to pay it off and this can be a psychological burden especially if you have high enough debt. Therefore, in developing the company as much as possible to reduce the costs incurred and avoid borrowing.

Well, that was the summary of leverage ratio which starts from the definition, function, type, to the risks that will be accepted by the company. So, consider carefully whether your company will use it or not.

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