Why Measure Financial Leverage?
A firm can finance its assets using borrowed funds, owners’ equity, or both. Financial leverage ratios summarize the relative amounts of these financing sources. They help analysts describe the financing mix and compare alternatives, but they do not, by themselves, establish whether a firm can meet its payments or whether its financing is appropriate.
This tutorial focuses on two ratios: debt-to-equity and debt-to-capital. To compare them meaningfully, first define what counts as debt and equity, then use those definitions consistently in both the numerator and denominator.
For a basic balance-sheet calculation, debt generally includes interest-bearing borrowings such as short-term loans and long-term borrowings. It does not automatically include every liability. Accounts payable and accrued operating expenses, for example, are liabilities but are not usually classified as financial debt for these two measures. Equity is the equity financing included in the stated calculation, commonly shareholders’ equity in a simplified balance-sheet problem. If a problem specifies a different classification, follow it and state the definition.
These definitions make \(D+E\) a deliberately defined financing total. It is not automatically the same as total assets, nor is it automatically total liabilities plus equity. A calculation that includes some liabilities as debt must identify them and use that classification consistently.
Calculating the Two Ratios
Debt-to-equity compares debt directly with equity. A result of \(0.80\), for instance, means that the firm has 80 cents of defined debt for each dollar of defined equity. The ratio can exceed 1:1 and has no fixed upper bound when equity is positive.
Debt-to-capital compares debt with the sum of debt and equity. A result of \(0.40\), or 40%, means that debt accounts for 40% of the capital defined as \(D+E\). When \(D\) and \(E\) are nonnegative and their sum is positive, this ratio lies between 0 and 1. It is often presented as a percentage.
Both measures describe a financing mix, but their denominators answer different questions. Debt-to-equity asks how much debt there is relative to equity. Debt-to-capital asks what fraction of the defined debt-and-equity total is debt. Therefore, a debt-to-equity ratio of 1.00 means debt equals equity, while a debt-to-capital ratio of 1.00 would require equity to be zero when debt is positive.
Worked Example: Separating Financial Debt From Other Liabilities
A hypothetical firm reports short-term borrowings of $18 million, long-term borrowings of $42 million, accounts payable of $22 million, and shareholders’ equity of $70 million. Using interest-bearing borrowings as debt, calculate both leverage ratios. Explain why accounts payable is not included in this calculation.
Method and classification. Treat the two borrowing balances as financial debt. Accounts payable is an operating liability, not an interest-bearing borrowing under the stated definition, so it is excluded from \(D\). The equity amount is the reported shareholders’ equity.
Step 1: Calculate debt. Add the short-term and long-term borrowings:
Step 2: Calculate debt-to-equity. Divide debt by equity:
To four decimal places, debt-to-equity is 0.8571, or about 85.71 cents of debt for each dollar of equity.
Step 3: Calculate debt-to-capital. First find the defined capital total, then divide debt by that total:
To four decimal places, debt-to-capital is 0.4615, or 46.15%.
Check and common mistake. The ratios are consistent: debt is less than equity, so debt-to-equity is below 1; debt is less than half of the $130 million defined capital total, so debt-to-capital is below 50%. Including accounts payable would change the definition to one that includes an operating liability. It would not be the calculation requested here.
How the Ratios Relate
When both ratios use the same \(D\) and \(E\), either can be calculated from the other. The relationship is useful as a check and explains why the two numbers are not independent descriptions of the same financing mix.
To justify the first relationship, write debt-to-capital using \(D/E\). Dividing the numerator and denominator of \(D/(D+E)\) by \(E\) is valid because \(E>0\):
Let \(x=D/E\) and \(r=D/(D+E)\). Then \(r=x/(1+x)\). Solving for \(x\) gives \(r(1+x)=x\), so \(r=x(1-r)\). If \(r<1\), divide by \(1-r\) to obtain \(x=r/(1-r)\). This also confirms that for nonnegative debt and positive equity, debt-to-capital is less than 1.
Worked Example: Converting Between the Ratios
A hypothetical company has debt-to-equity of 0.75. Its defined debt and equity use the same date and measurement basis. Find debt-to-capital, then verify the result using balances of $60 million in debt and $80 million in equity.
Method. Use the algebraic relationship between the ratios, which applies because the definitions of debt and equity are identical in both measures.
Step 1: Convert the ratio.
Debt-to-capital is 42.86% to two decimal places.
Step 2: Verify with the balances. The stated balances give \(D/E=60/80=0.75\). Their defined capital total is \(60+80=140\) million dollars, so:
Check and common mistake. The two methods agree. A common error is to divide \(0.75\) by 1, or to interpret 0.75 as debt-to-capital. The correct denominator for debt-to-capital is \(D+E\), which produces the conversion \(x/(1+x)\), not \(x\).
Using the Ratios to Compare Financing Choices
A financing decision can change one or both components of the defined capital total. Recalculate the balances after the transaction rather than assuming that a ratio changes by the same amount as the dollar financing raised. The transaction’s purpose matters: borrowing to fund an investment is different from borrowing and distributing the proceeds to shareholders.
Worked Example: Comparing Debt and Equity Financing
A hypothetical company currently has $60 million of debt and $120 million of equity. It is considering a $30 million investment. Under Plan A, it borrows the full $30 million. Under Plan B, it raises the full $30 million as equity. Assume the investment is made immediately, the funds are used for the investment, and there are no fees or other balance changes. Calculate both ratios before and after each plan.
Method and assumption. Recalculate \(D\), \(E\), and \(D+E\) after each transaction. Under Plan A, debt increases by $30 million while equity is unchanged. Under Plan B, equity increases by $30 million while debt is unchanged.
Current financing. The initial capital total is \(60+120=180\) million dollars. Therefore:
Initially, debt-to-equity is 0.50 and debt-to-capital is 33.33%.
Plan A: Borrow $30 million. After borrowing, \(D=60+30=90\) million dollars and \(E=120\) million dollars. The defined capital total is \(90+120=210\) million dollars:
After Plan A, debt-to-equity is 0.75 and debt-to-capital is 42.86%.
Plan B: Raise $30 million of equity. After the equity financing, \(D=60\) million dollars and \(E=120+30=150\) million dollars. The defined capital total is \(60+150=210\) million dollars:
After Plan B, debt-to-equity is 0.40 and debt-to-capital is 28.57%.
Check and common mistake. Both plans add the same $30 million to the defined capital total, but they do not produce the same debt share. Borrowing increases the debt numerator, while equity financing increases the denominator without increasing debt. Do not add the $30 million investment itself to equity: under the stated assumptions, the financing balances—not the asset purchased—determine these ratios.
Interpretation and Limits
A higher debt-to-equity ratio means more defined debt relative to equity; a higher debt-to-capital ratio means debt forms a larger share of defined capital. Those statements describe composition, not credit quality or the ability to service debt. A firm with a high ratio might have stable cash flows, while a firm with a lower ratio might still face payment difficulties. The ratios alone do not measure interest coverage, cash availability, or the variability of earnings.
Comparisons are most informative when the firms’ debt and equity definitions, reporting dates, and measurement bases are comparable. Even with consistent calculations, differences in business activities and financing needs can affect interpretation. A ratio is a summary, not a complete financing analysis. In a decision context, analysts should also ask what the proposed transaction does to the balances and whether other relevant risks or constraints are being considered.
- Use a defined debt numerator. Do not silently treat all liabilities as financial debt.
- Keep the equity denominator consistent. The same equity definition must be used in debt-to-equity and debt-to-capital.
- Build the capital denominator explicitly. For this measure, defined capital is \(D+E\), not automatically total assets.
- Interpret the direction, not just the number. A larger debt share indicates a more debt-heavy financing mix, but does not alone prove that financing is unsustainable.
Check Your Understanding
For each problem, identify the relevant financing balances before calculating. Amounts are in millions of dollars unless noted.
- A hypothetical firm has $15 million of interest-bearing debt and $45 million of equity. Calculate debt-to-equity and debt-to-capital. (Answer: \(0.3333\) and \(25.00\%\), respectively.)
- A company has short-term borrowings of $12 million, long-term borrowings of $28 million, accounts payable of $10 million, and equity of $50 million. Using interest-bearing borrowings as debt, calculate both ratios and state whether accounts payable is included. (Answer: Debt is $40 million; debt-to-equity is \(0.8000\), debt-to-capital is \(44.44\%\), and accounts payable is excluded.)
- A firm’s debt-to-equity ratio is 0.75 and its equity is $80 million. Find its debt and debt-to-capital ratio. (Answer: Debt is $60 million; debt-to-capital is \(42.86\%\).)
- A hypothetical firm has $25 million of debt and $75 million of equity. It borrows another $15 million to fund an investment, with no other balance changes. Calculate both ratios after the transaction. (Answer: Debt is $40 million and equity is $75 million; debt-to-equity is \(0.5333\), debt-to-capital is \(34.78\%\).)
- A firm has defined capital of $200 million and debt-to-capital of 35%. It plans to change its financing mix to debt-to-equity of 0.75 while keeping defined capital at $200 million. Find its current debt, then find the target debt and equity balances and the increase in debt required. (Answer: Current debt is $70 million. Target debt is approximately $85.71 million and target equity is approximately $114.29 million; debt must increase by approximately $15.71 million.)