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Leverage Ratio: Types, Examples, & How To Calculate It

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Written by Timothy Sykes
Updated 7/8/2021 15 min read

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.

It also seems like there are endless technical and fundamental indicators. I know most day traders focus mainly on technical analysis. But you should never completely overlook a company’s financials.

I’ve traded stocks that are drowning in debt with no hope for the future. But that’s the key: I trade these stocks. I don’t invest in them.

And I know these companies are garbage because I often check the balance sheet. They usually have little to no cash or revenues.

With these stocks, it’s better to get in and out quickly. The stock’s future is often a big downtrend. It doesn’t matter how high a pump or promotion spikes it.

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.

Let me show you how you can use this number to evaluate companies and stay safe

What Are Leverage Ratios?

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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.

Penny stocks often aren’t what they seem. It’s smart to check under the hood before you buy the car.

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.

Your broker might offer you leverage. Brokers let traders with margin accounts borrow money to buy shares. But if you borrow any money, you have to repay it with interest.

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.

But you need to think about what happens when trades go bad. Don’t kid yourself. It happens to everybody.

Never risk more money than you can afford to lose in the stock market. Trading with money you don’t have is a quick way to blow up your account or, worse, go into debt.

If I’ve seen it once, I’ve seen it a thousand times. Some newbie starts trading stocks and gets lucky. They think they’ve figured out a secret to the market and start leveraging their positions.

A couple of trades later, they’ve lost it all — and more — on a trade they couldn’t cut.

Don’t be that newbie. Surviving in the market is HARD. Making money in the stock market is harder. I know from personal experience after trading for 20+ years and teaching for over 10.

Now I want to use all the knowledge I’ve accumulated to help anyone dedicated to learning. Check out my FREE online guide to penny stocks and start your journey today.

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.

I’ve always said, you don’t need to be smart to trade stocks. You just need rules, dedication, and discipline.

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?

Know what you’re buying. The stock market isn’t Las Vegas. Your broker isn’t a slot machine.

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.

Extra Tip

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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.

Always do your due diligence and trade with a plan. Before you add leverage ratios to your trading strategy, make sure you know what types you’re using.

Types of Leverage Ratio

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Remember when I said there are several different types of leverage? Let’s run through a few…

Operating Leverage

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.

Financial Leverage

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.

Combined Leverage

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…

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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.

Don’t expect each of these indicators to behave the same. Prepare for inevitable changes in the market and how that can impact each ratio.

Debt-to-Equity Ratio

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.

Equity Multiplier

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

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I know. Leverage ratio isn’t the most exciting topic. But it’s important to improve your knowledge account before your trading account.

Ready to work to become a self-sufficient trader? It’s not an easy road. All my top students studied for years before reaching consistency.*

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.

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*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.

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Timothy Sykes

Tim Sykes is a penny stock trader and teacher who became a self-made millionaire by the age of 22 by trading $12,415 of bar mitzvah money. After becoming disenchanted with the hedge fund world, he established the Tim Sykes Trading Challenge to teach aspiring traders how to follow his trading strategies. He’s been featured in a variety of media outlets including CNN, Larry King, Steve Harvey, Forbes, Men’s Journal, and more. He’s also an active philanthropist and environmental activist, a co-founder of Karmagawa, and has donated millions of dollars to charity. Read More

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* Results are not typical and will vary from person to person. Making money trading stocks takes time, dedication, and hard work. There are inherent risks involved with investing in the stock market, including the loss of your investment. Past performance in the market is not indicative of future results. Any investment is at your own risk. See Terms of Service here

The available research on day trading suggests that most active traders lose money. Fees and overtrading are major contributors to these losses.

A 2000 study called “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” evaluated 66,465 U.S. households that held stocks from 1991 to 1996. The households that traded most averaged an 11.4% annual return during a period where the overall market gained 17.9%. These lower returns were attributed to overconfidence.

A 2014 paper (revised 2019) titled “Learning Fast or Slow?” analyzed the complete transaction history of the Taiwan Stock Exchange between 1992 and 2006. It looked at the ongoing performance of day traders in this sample, and found that 97% of day traders can expect to lose money from trading, and more than 90% of all day trading volume can be traced to investors who predictably lose money. Additionally, it tied the behavior of gamblers and drivers who get more speeding tickets to overtrading, and cited studies showing that legalized gambling has an inverse effect on trading volume.

A 2019 research study (revised 2020) called “Day Trading for a Living?” observed 19,646 Brazilian futures contract traders who started day trading from 2013 to 2015, and recorded two years of their trading activity. The study authors found that 97% of traders with more than 300 days actively trading lost money, and only 1.1% earned more than the Brazilian minimum wage ($16 USD per day). They hypothesized that the greater returns shown in previous studies did not differentiate between frequent day traders and those who traded rarely, and that more frequent trading activity decreases the chance of profitability.

These studies show the wide variance of the available data on day trading profitability. One thing that seems clear from the research is that most day traders lose money .

Millionaire Media 66 W Flagler St. Ste. 900 Miami, FL 33130 United States (888) 878-3621 This is for information purposes only as Millionaire Media LLC nor Timothy Sykes is registered as a securities broker-dealer or an investment adviser. No information herein is intended as securities brokerage, investment, tax, accounting or legal advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation or sponsorship of any company, security or fund. Millionaire Media LLC and Timothy Sykes cannot and does not assess, verify or guarantee the adequacy, accuracy or completeness of any information, the suitability or profitability of any particular investment, or the potential value of any investment or informational source. The reader bears responsibility for his/her own investment research and decisions, should seek the advice of a qualified securities professional before making any investment, and investigate and fully understand any and all risks before investing. Millionaire Media LLC and Timothy Sykes in no way warrants the solvency, financial condition, or investment advisability of any of the securities mentioned in communications or websites. In addition, Millionaire Media LLC and Timothy Sykes accepts no liability whatsoever for any direct or consequential loss arising from any use of this information. This information is not intended to be used as the sole basis of any investment decision, nor should it be construed as advice designed to meet the investment needs of any particular investor. Past performance is not necessarily indicative of future returns.

Citations for Disclaimer

Barber, Brad M. and Odean, Terrance, Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. Available at SSRN: “Day Trading for a Living?”

Barber, Brad M. and Lee, Yi-Tsung and Liu, Yu-Jane and Odean, Terrance and Zhang, Ke, Learning Fast or Slow? (May 28, 2019). Forthcoming: Review of Asset Pricing Studies, Available at SSRN: “https://ssrn.com/abstract=2535636”

Chague, Fernando and De-Losso, Rodrigo and Giovannetti, Bruno, Day Trading for a Living? (June 11, 2020). Available at SSRN: “https://ssrn.com/abstract=3423101”