A negative leverage ratio is one of many factors which can lead analysts to be concerned about the financial health of a company. Understanding how a negative leverage ratio may come about is just as important as understanding how to can be resolved. Analysts use the the leverage ratio as a measure of the effectiveness of debt-versus-equity investing decisions. These ratios help illustrate debt's impact on the balance sheet, and can act as a good indicator for investors as to whether or not their equity in a company is 0n track to deliver their anticipated return.
What Is Financial Leverage?
Financial leverage refers to the level of debt a company takes on to fund day-to-day operations, purchase assets or finance expansion. The deductions that a company takes for interest payments may mitigate the negative impact of interest expenses on profits, since the deductions also reduce the company's tax burdens. In addition, the more debt a company takes on, the less equity it needs. Financial leverage increases financial risk, but it also increases the return on equity for shareholders.
How Leverage Ratios Work
Leverage ratios are typically stated in percentages. These ratios measure how much debt relative to other variables is on a company's balance sheet. Leverage ratios include the debt-to-assets ratio and debt-to-equity ratio. Higher ratios indicate higher debt levels. Generally, the higher the debt, the riskier the company and riskier its stock. All creditors and debt holders have first claim to a company's assets in the event of failure. If a company with high debt levels fails, its shareholders may not receive anything.
What Is Negative Leverage?
Negative leverage occurs when a company purchases an investment using borrowed funds, and the borrowed money has a greater cost, or higher interest rate, than the return made on the investment. This sometimes occurs when companies use adjustable rates to purchase or construct property, and interest rates rise rapidly. Negative leverage also results from a negative stockholders' equity or net worth.
This typically occurs when a company has had problems raising money to cover historical net losses. Those net losses accrue and eventually surpass the equity from issued stock.
Negative Leverage Ratio
In general, company leadership and investors are comfortable with a certain level of debt and leverage due to the potentially higher return on equity it generates. Most typically, a negative leverage ratio refers to the negative return on equity that results from the higher interest on debt than the investment return, but a negative leverage ratio may also refer to the debt-to-equity ratio resulting from a company with a negative net worth.
Identifying an Example
ABC Company obtains a construction loan at a 5.5-percent interest rate to build a warehouse. The company sells the warehouse and generates a 4-percent return on its investment. This results in a return on equity of negative 1.5 percent. XYZ Company has debt of $40 million and equity of negative $10 million, resulting in a debt-to-equity ratio of negative 4-to-1. Both of these are negative leverage ratios.
Tiffany C. Wright has been writing since 2007. She is a business owner, interim CEO and author of "Solving the Capital Equation: Financing Solutions for Small Businesses." Wright has helped companies obtain more than $31 million in financing. She holds a master's degree in finance and entrepreneurial management from the Wharton School of the University of Pennsylvania.