The Leverage ratio is the way to indicate the risk factor of banks, if the leverage ratio is too high then the risk of the bank is high. There are certain percentage of the fall in earnings the banks can handle without distressing the health of the bank. The leverage ratio is asset to equity. After obtaining the leverage ratio then we can find by how much the fall in the earning banks can handle.
Leverage = Asset / Equity
Risk = 1 / Leverage Ratio
Comparing the leverage ratio of 3 Banks
BANK A 2015
Total Asset: 500,000
Total Liabilities: 350,000
Total Equity: 55,000
The Leverage Ratio: 500,000/55,000=9.91
Risk factor in falling of earnings: (1/9.91)x100=11%
The Leverage ratio of Bank A is 9.91 and if Bank A has more than 11% fall in the earnings then the bank will be at risk. Bank A can bare up to 11% fall in the earnings.
BANK B 2015
Total Asset: 400,000
Total Liabilities: 300,000
Total Equity: 35,000
The Leverage Ratio: 400,000/35,000=11.43
Risk factor in falling of earnings: (1/11.43)x100=8.75%
The Leverage ratio of Bank B is 11.43 and if the earnings falls by more than 8.75% then the bank will be at risk. The high the risk factors in falling of earnings then better it is because that is the percentage in fall the banks can bare without going into financial distress.
BANK C 2015
Total Asset: 350,000
Total Liabilities: 300,500
Total Equity: 50,000
The Leverage Ratio: 350,000/50,000=7
Risk factor in falling of earnings: (1/7)x100=14.3%
The Leverage ratio of Bank C is 7 and if the earnings of Bank C falls by more than 14.3% then the bank will be at risk.
When we compare all three Banks the Bank C has the lowest leverage ratio which means the Bank C has the lowest risk of financial distress.