How Leverage Ratio can tell you whether you are high risk or low risk?
Leverage ratio also called as debt to equity ratio is the measure of the role of debt in an asset build-up of an investor or a company. An investor or company can compute their leverage ratio and check whether their financial situation is high risk or low risk. In this article, we would restrict the discussion to individual leverage ratio only. What is Leverage Ratio of an individual? How to check whether your leverage ratio is a high risk low risk? When should you take action to improve the financial leverage ratio?
What is Leverage Ratio of an individual?
Leverage ratio is the measure of debt over the total assets of an investor or company. This is calculated as total liabilities / total assets. There are several sub classifications of ratios under leverage ratios, but we would restrict only to simple leverage ratio for an individual in this article. Some argue, we may not need to do this for individual. But what happens if we apply for individual financial status? It gives altogether a new dimension when one look at their leverage ratio. Some times one may get surprised with the results.
How to compute Leverage Ratio of an individual?
This is calculated as total liabilities over total assets. The ratio is either <1 or 1 or >1. It is also represented in %ages like 20% or 100% or 150%. Let me explain with some examples.
Example No.1 – Low Leverage Ratio
Mr.Rajesh has a house worth Rs 50 Lakhs, investments in mutual funds for Rs 30 Lakhs and investments in provident fund for Rs 20 Lakhs. He bought the house with home loan for Rs 40 Lakhs and current outstanding is Rs 30 Lakhs. He has personal loan for Rs 10 Lakhs.
Total assets = Rs 50 Lakhs + Rs 30 Lakhs + Rs 20 Lakhs = Rs 1 Crore
Total liabilities = Rs 30 Lakhs + Rs 10 Lakhs = Rs 40 Lakhs.
Leverage Ratio of Mr.Rajesh = Rs 40 Lakhs / Rs 1 Crore = 0.4 or 40%
Example No.2 – Moderate to High Leverage Ratio
Mrs.Arpitha has real estate worth Rs 95 Lakhs and investments in provident fund for Rs 5 Lakhs. She bought real estate with a home loan and current outstanding home loan is Rs 78 Lakhs. She has personal loan for Rs 20 Lakhs. Her credit card outstanding is Rs 2 Lakhs now.
Total assets = Rs 95 Lakhs + Rs 5 Lakhs = Rs 1 Crore
Total liabilities = Rs 78 Lakhs + Rs 20 Lakhs + Rs 2 Lakhs = Rs 1 Crore.
Leverage Ratio of Mrs. Arpitha = Rs 1 Crore / Rs 1 Crore = 1 or 100%
Example No.3 – Very High Leverage Ratio
Mr.Mahesh has real estate worth Rs 95 Lakhs and investments in provident fund for Rs 5 Lakhs. He bought real estate with a home loan and current outstanding home loan is Rs 78 Lakhs. He has personal loan taken from bank for Rs 20 Lakhs. His credit card outstanding is Rs 2 Lakh now. He also owes Rs 20 Lakhs to his friends.
Total assets = Rs 95 Lakhs + Rs 5 Lakhs = Rs 1 Crore
Total liabilities = Rs 78 Lakhs + Rs 20 Lakhs + Rs 2 Lakhs + Rs 20 Lakhs = Rs 1.2 Crore.
Leverage Ratio of Mr.Mahesh = Rs 1.2 Crore / Rs 1 Crore = 1.2 or 120%
How to interpret the leverage ratio of an individual?
Leverage ratio is the debt portion of the total assets.
Leverage Ratio > 1 – This means that the individual has higher liabilities compared to their assets. Their financial profile is HIGH RISK.
Leverage Ratio = 1 – This means that the individual has equal liabilities compared to assets. However, if the interest rates increases or value of current assets decreases, they would move to higher leverage ratio > 1. This segment of individuals is considered under moderate risk.
Leverage Ratio < 1 – This means that the individual has lower liabilities compared to their assets. Their financial profile is LOW RISK.
Pros of having a higher leverage ratio for an individual
Here are some positives.
1) One can purchase more assets through debt financing with extra funds (beyond own funds).
2) Under favorable conditions, such higher leverage ratio leads to higher returns
Cons of having a higher leverage ratio for an individual
Here are some negative factors.
1) Under unfavorable conditions, value of assets can decline.
2) There is a chance that in case of higher leverage ratio can make the individual bankrupt too. E.g. one has too many loans and invested in real estate. In the short term, unable to sell real estate (due to lack of demand or due to correction in real estate prices), but there is pressure to payoff loans.
What actions an individual need to take bring down the high leverage ratio?
Once individual computes their leverage ratio and if they are falling under >=1, they should take appropriate steps.
1) The high leverage ratio is okay when you are young. You have just started to earn money and would have taken home loan or car loan, etc. However, ensure that such loans are used majorly for asset creation and not as an expense (e.g. Personal loan taken for real estate is okay rather than using for a vacation). One can also check on good investment options for youngsters to grow their money faster.
The high leverage ratio is also okay as long as assets are NOT a risky investment option (e.g. Major investment in stocks and the stock market have reached its peak like now. If there is a huge market correction, the portfolio value would fall drastically)
2) If you are in the middle age of say, in 40’s, ideally the leverage ratio should be < 1. The reason is that you have earned some good amount of money by then. If not, you need to work on reducing your liabilities one by one. e.g. LIC Housing has come up with low home interest rate home loan which is sure shot bet to reduce your home loan EMIs.
3) If you are in between 50’s to 60’s, your ideal leverage ratio should be very low. The reason is that you have earned enough money and only a small portion of your assets is funded by debt. If this is not the case, you are in serious financial problem for which you need to work.
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