A lot of traders are on the hunt for the best way to use the leverage ratio or the best leverage ratio formula.
I get that. There are many ways to use and calculate this number.
And I know these companies are garbage because I often check the balance sheet. They usually have little to no cash or revenues.
I know the patterns well, so I’m ready to take the meat of the move and get out with safe profits.* It’s worked pretty well for me so far. I’ve been able to profit for over two decades in the stock market. Now I teach my strategies. And several of my students excel in this niche too.*
The key is education and safety. You’ve gotta know what you’re trading to stay realistic.
Leverage ratios can help traders learn more about individual stocks. That way they can make better trades.
Table of Contents
- 1 What Are Leverage Ratios?
- 2 How Is Leverage Created?
- 3 How Leverage Ratio Works
- 4 Why Is Leverage Ratio Important?
- 5 Types of Leverage Ratio
- 6 Common Leverage Ratios
- 7 Leverage Ratio Examples
- 8 Frequently Asked Questions About Leverage Ratio
- 9 The Leverage Ratio Conclusion
What Are Leverage Ratios?
Let’s dissect this a bit.
Using leverage involves borrowing money. Here’s an example: Traders can borrow money from brokers and use that leverage to buy more shares. Companies can borrow money from banks to invest in their business.
So when we talk about the leverage ratio for a company, we’re looking at how much debt it has compared to things like its equity and assets.
For example, if a stock is spiking on recent news, I might check a stock’s financial records. It’s important to keep things in perspective. Even though the news sounds good, the company could be in debt. It might affect whether or take the trade or not. But I like to go in with my eyes open.
How Is Leverage Created?
There are lots of different kinds of leverage.
Businesses have two main ways of creating more buying power … They can either borrow money from a bank or sell stock to investors.
I don’t recommend trading with leverage. I know it seems attractive. Larger position sizes mean the possibility of more profit when trades go well.
A couple of trades later, they’ve lost it all — and more — on a trade they couldn’t cut.
How Leverage Ratio Works
Maybe we should break down some calculations. Don’t worry — it’s nothing too crazy. I was a philosophy major. Math is not my strong suit.
There are a few different ways to calculate leverage ratios. We’ll go over those later. But let me give you a sense of what to look for…
Formulas calculate ratios by dividing total debt by other factors like total assets. That way you can get an idea of how much the debt company has.
High leverage ratios mean that the company has large amounts of debt. Low ratios mean less debt.
That sounds simple. For now, know the basics and that there are many ways to calculate leverage ratios. Don’t forget different ratios give you different numbers.
It’s up to you to figure out what the ratio means for the company and the stock.
Why Is Leverage Ratio Important?
Remember that 90% or more of traders lose. So prepare before going into every trade.
Most of the stocks I trade are dumpster fire companies. They have little to no revenues and sometimes don’t even have a product. Companies like this exist to sell stock.
I’m not saying you shouldn’t trade these stocks. But I am saying you MUST know what you’re trading.
Ratios like the leverage ratio can help you determine a company’s health and whether its debt is too large.
By checking multiple financials and indicators, I can make a better-informed trade.
Yes, I may trade a company with tons of outstanding debt. But by knowing that I can keep my expectations in check. And I can adjust my strategy.
I made the mistake of trusting a penny stock once. That was back in my early days of trading. I blew up a pretty good portion of my hedge fund because I fell in love with the company. You can read all about it in my book “An American Hedge Fund.”
Don’t make the same mistakes I did.
Let’s be clear. I’m a day trader. Sometimes I’ll hold a stock overnight, but that doesn’t happen often. The market conditions lately haven’t been right.
But if I did make a swing trade, the leverage ratio might matter more. Why?
Every time you hold overnight, you give yourself up to the mercy of the market. A stock that’s debt dependent — or high ratio — and low float might offer more shares in after-hours or premarket trading. That could make the price crash once the market opens again.
See? It’s good to keep things in perspective.
Types of Leverage Ratio
Remember when I said there are several different types of leverage? Let’s run through a few…
This is a business’ leverage created from sales. It’s a ratio of fixed costs to revenue. It helps determine company performance. Specifically, it looks at where firms use their money.
Businesses with high operating costs may have a more difficult time making profits. Think Ford Motor Company (NYSE: F) or General Motors Company (NYSE: GM) for example. Car manufacturers often have high fixed costs.
A high ratio would mean costs are creeping up on revenues. The boat’s sinking.
A low ratio is a healthy operating range. Revenues are higher than costs and the company is likely making money.
Sales influence this ratio more easily. That’s a good thing to keep in mind when going through the financials. Always remember what the ratio measures and the overall implication of the ratio.
This is leverage the company gains from selling stock to shareholders. This ratio is a bit different. It still measures company performance and distribution of money. But now it’s a factor of debt to equity.
More debt than stockholder equity means the company relies more on debt. A high ratio would mean debt funds most of the company’s investments.
A low ratio means there’s a low amount of debt. The business invests more from stockholder equity.
This is pretty straightforward. It’s a combination of operating leverage and financial leverage. They measure two different parts of the same company so you can use both to get a better picture.
Operating leverage is sales driven and financial leverage is stockholder driven.
Using both is like putting two puzzle pieces together.
Common Leverage Ratios
There’s a lot of different ways to measure a company’s leverage. That should be no surprise.
Have you seen a company’s financial statements before? There are so many numbers, it can make your head spin. And analysts like to come up with new ways to look at stocks, companies, and the market.
The debt-to-equity ratio is a popular leverage ratio. The equity multiplier is another one you might come across, so I’ll break that down too.
Keep reading to see how these tools can help your trading…
Leverage Ratio Examples
My biggest tip when it comes to using a ratio is to always remember what the ratio measures. A tool is only as good as the person using it.
This is measured by dividing a company’s debt by shareholder equity.
Remember from earlier … Financial leverage is a measure of shareholder equity as well. So essentially, the debt-to-equity ratio is a measure of a company’s financial leverage.
A high ratio means the company is debt burdened. That’s not a good sign for holding long term.
This one is similar to the debt-to-equity ratio. It looks at all the same factors, but the calculation is a bit different.
The ratio is a company’s assets divided by its shareholder equity.
Don’t get confused. Debt plus equity equals assets. So the ratio measures a company’s debt but adds its equity before dividing. Find this too muddled? Remember…
You don’t have to use every leverage ratio or every indicator. It’s impossible to watch them all at once and still have time to make a trade. Test different ratios in your strategy and see what works for you.
Frequently Asked Questions About Leverage Ratio
It’s a tricky topic, which means more questions. Let’s get to ‘em.
What Are the Types of Leverage Ratio?
There are many different types of leverage ratios. You can measure operating leverage and financial leverage. Analysts copy that data into formulas that spit out tons of ratios. What matters most is finding the ratios and indicators that work for your trading strategy.
What Are the Risks of High Operating Leverage and High Financial Leverage?
A business experiencing both of these is likely a terrible long-term investment. It means there are high operating costs and debt. There might not be enough cash to cover its expenses. You could potentially trade it short term. But don’t trust companies that hemorrhage cash.
What Is the Leverage Ratio for Banks?
It determines how much a bank can lend. The ratio differs between banks. It depends on factors like cash holdings and outstanding debt.
The Leverage Ratio Conclusion
I know. Leverage ratio isn’t the most exciting topic. But it’s important to improve your knowledge account before your trading account.
But they all got their start in my Trading Challenge. If you want to start taking your education seriously, apply today. I don’t accept everyone. You have to go through an interview to show me and my team you’re willing to do what it takes.
Today I taught you how to measure a company’s performance and level of debt with leverage ratios. Now it’s your turn to practice using that knowledge. Go look for examples and patterns in the stock market. Build a trading plan that works for you and only take trades that are safe for your setups and risk management.
What do you think about leverage ratios? How do you use them for analysis? I love to hear from all my readers. Comment below.
*Please note that these kinds of trading results are not typical. Most traders lose money. It takes years of dedication, hard work, and discipline to learn how to trade. Individual results will vary. Trading is inherently risky. Before making any trades, remember to do your due diligence and never risk more than you can afford to lose.