Term
Leverage ratio
The share of borrowed funds in financing a company, most often liabilities to assets or to equity. High leverage raises risk, and banks monitor it through covenants.
Updated
What it means
Indebtedness shows the extent to which a company is financed by borrowed funds, meaning loans, credit, amounts owed to suppliers and other debts, compared with equity. It is one of the basic ratios of financial analysis and indicates the company’s financial risk.
It is most often calculated as total liabilities as a share of total assets, or as the ratio of liabilities to equity. Banks also frequently use net debt to EBITDA, which shows how many years the company would need to repay its interest-bearing debt from operations.
Reasonable indebtedness is not a bad thing. Borrowed capital is often cheaper than equity and, through financial leverage, can increase owners’ returns. Too much debt, however, raises the risk that the company cannot repay when times get harder.
How it works in practice
In the annual analysis we give clients an overview of indebtedness over time and compared with the sector. When they apply for a loan, we calculate in advance how the ratios will change after the new borrowing, because banks have internal limits for them.
Loan agreements often contain financial covenants, such as a maximum net debt to EBITDA ratio. We set up monitoring of these ratios during the year so that a breach is not discovered only at year end, when the bank may already be able to call the loan.
Where indebtedness is high, we look with the client for ways to improve: reducing inventory and receivables, selling idle assets, refinancing over a longer term, or strengthening equity with a shareholder contribution.
What to watch out for
Balance sheet indebtedness does not capture everything. Operating leases, guarantees of others’ debts and other contingent liabilities do not appear in it, although they are real obligations. When assessing risk we therefore also look at the notes.
High indebtedness combined with losses and negative equity may mean the company is in crisis under the Commercial Code. Restrictions on repaying shareholder loans then apply and directors bear increased liability, as an Altman Z-score may also signal.
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