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Leverage

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Leverage is the amount of debt a company has in its mix of debt and equity (its capital structure). A company with more debt than average for its industry is said to be highly leveraged.

Leverage is not necessarily bad. When revenues are growing, payments are made with comfortable surpluses and additional debt is acquired to take advantage of market opportunities.

However, when revenues are low, a highly leveraged business might fall behind on debt payments and it might not be able to borrow additional money to stay afloat.

Two ratios are used to measure a company’s leverage: Debt-to-equity and debt-to-total-assets. Comparing these ratios with those from other companies in the same industry illustrates their utility.

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In the example below, two companies in the same industry have assets of $1,000,000.

Company A has total debt of $250,000 and total shareholder’s equity of $750,000.

  • Its debt-to-equity ratio is:

    $250,000 / $750,000 = .33:1
    In other words, for every dollar the company has borrowed, shareholders have contributed $3.
  • Its debt-to-total-assets ratio is:

    $250,000 / $1,000,000 = 25%
    Its capital structure is 25% debt and 75% equity.

Company B has total debt of $750,000 and total shareholders’ equity of $250,000.

  • Its debt-to-equity ratio is:

    750,000 / 250,000 = 3:1
    In other words, for every dollar contributed by shareholders, the company has borrowed $3.
  • Its debt to total assets ratio is:

    750,000 / 1,000,000 = 75%
    It’s capital structure is 75% debt and 25% equity.

Here, Company B is much more highly leveraged than Company A. When markets are growing, Company B will do well. But during a market downturn, it will struggle. A long period of slow growth risks making Company B insolvent.

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