Debt divided by debt plus equity is one way of calculating the leverage of a corporation. This basic ratio will provide an idea about how aggressively a firm has borrowed. Companies with high leverage do well in good times but lose far more money when business isn't so good. A high leverage ratio indicates a high-risk, high-return strategy.
The balance sheet of any corporation, or even that of a household, has two sides. The assets, which includes all tangible and non-tangible valuables owned by the company are on one side, while liabilities and shareholder equity are on the other side. The total dollar figures on each side are always equal, no matter what kind of shape the firm is in. This is because an adjustment of equal magnitude is made to both sides of the balance sheet after every transaction. As a result, the assets match the liabilities plus equity at all times. In simpler terms, what is owned always equals what is owed. Shareholder equity can be thought of what the firms owes its stockholders, while debt is what is owed to creditors.
Financial leverage refers to what portion of a financial operation is financed through borrowing. When you buy a $1 million house by putting up a $100,000 down payment and a $900,000 mortgage, then 90 percent of the home's value is financed by debt. Hence, the leverage ratio is 90 percent. The same value can be calculated for a corporation by dividing its debt to the sum of its debt plus its equity. Since debt plus equity always equals assets, a different way of performing the calculation is to divide total debt by total assets. The resulting figure will show how much of the firm's operation is financed debt.
A corporation can end up with a high leverage ratio due to two reasons. The assumption of a lot of debt can be the result of a strategic decision. Assume a firm sells 1 million pair of shoes a year, making a net profit of $4 million per year. If management has a particularly positive outlook and thinks it could sell 2 million more pairs if only it could manufacture them, the firm could borrow, say, $5 million to expand its factory. Further assume that the loan carries an annual interest payment of $500,000. If the forecast is accurate and 6 million pairs are sold, the additional $2 million in profits will more than make up for the $500,000 in interest payment and net profits will increase. If, however, sales do not increase, the interest payment will eat into profits and repayment of the principal amount borrowed will pose serious problems.
A company can also end up with a high leverage ratio as a result of an inability to finance ongoing operations through accumulated profits or shareholder equity. A supermarket chain that isn't very profitable or operating at a loss, for instance, may have to ask food manufacturers for longer and longer payment terms, thus accumulating a great amount of debt to suppliers. Such debt is particularly dangerous as the firm would get into serious trouble if angry manufacturers stop deliveries until full payment of all outstanding debt is made. Another way to end up with large amounts of debt is to borrow more to pay for old debt, which too causes serious long term problems.