How To Calculate Leverage Ratios: Equity vs. Debt

There are several different ratios to use in order to assess the leverage of a company. The debt-to-equity ratio, or debt-to-total-capital ratio, compares how much of a company's funding comes from equity versus debt. To calculate the debt-to-equity ratio, we take the total interest-bearing liabilities, including current and non-current items, and divide them by total shareholders' equity. If the ratio is greater than 100, it means the company has more financing coming from debt than equity. If, however, we use the debt-to-total-capital ratio, we take the total interest-bearing liabilities and divide it by shareholders' equity plus total interest-bearing liabilities. In this case, if the ratio is greater than 50%, it means more than half of the company's financing comes from debt. The debt-to-tangible net worth takes the interest-bearing liabilities and divides them by equity less intangible assets. This ratio is useful when it's important to understand how many physical assets a company has. The tangible net worth, as the name implies, captures only the physical assets of the company and not the intangible ones. This tangible net worth number represents the proceeds that could be available if the company were to be quickly sold. A ratio of one times would be considered acceptable in most industries. However, it's better to have the ratio less than one, and if it's greater than one, then some attention needs to be paid as to what's happening and how the company is servicing that debt. Next, we have the total liabilities-to-equity ratio. In this case, we take all liabilities, including non-interest-bearing debts. For example, accounts payable would be included in total liabilities. This way, we can assess the company's obligations, including its short-term working capital requirements, and then comparing that to the total amount of equity in the business. By using this ratio in conjunction with the debt-to-equity ratio, it is then possible to see the impact of operational activities on the business. Meaning, is working capital tying up a lot of money on the balance sheet? Then we can look at total assets-to-equity. In this ratio, we take all of the assets and divide them by the equity. This is another way of slicing and dicing the leverage relative, in this case, to assets. This ratio can also be used in conjunction with the debt-to-equity ratio in order to find the sweet spot with the right amount of leverage for the business. Finally, we have the debt-to-EBITDA ratio. This ratio, unlike all of the other ones, requires the income statement in conjunction with the balance sheet. In this case, we take the total interest-bearing liabilities and divide them by earnings before interest, taxes, depreciation, and amortization. This is a common way of referring to how levered a company is. For example, is it levered at 2, 3, or 4 times EBITDA? EBITDA is often used as a proxy to cash flow. Even though, as you will have learned in several other CFI courses, it may be very far from a true cash flow metric since it does not include capital expenditures or any changes in working capital. But, it is used quite frequently in the industry and lenders often refer to the amount of leverage or the amount of gearing that a company can handle as a multiple of EBITDA.