Leverage Ratios

A class of ratios that measure the indebtedness of a firm

What are Leverage Ratios?

A leverage ratio is any kind of financial ratio that indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. It provides an indication of how much assets are coming from loans to finance business operations

Common Leverage Ratios

There are several difference leverage ratios. Some accounts that are considered to have significant comparability to debt are total assets, total equity, operating expenses and incomes, and interest expense.

Below are just two of these accounts and the ratios that use them:

Debt-to-Asset Ratio = Total Debt / Total Assets

Debt-to-Equity Ratio = Total Debt / Total Equity

Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization

In Practice

If a business has total assets worth $100 million, with total liabilities of $45 million, and total equity of $55 million, then the proportionate amount of borrowed money against total assets is .045 or less than half of its total resources. When comparing debt to equity, the ratio for this firm is 0.82 meaning equity still makes up a majority of the firms assets. This firm is, thus, quite leveraged.

Importance and Usage

Leverage ratios represent the extent to which a business is utilizing borrowed money. It also evaluates company solvency and capital structure. Having high leverage in a firms capital structure can be risky, but is also quite beneficial during times when the firm is earning. On the other hand, however, a highly levered firm will have trouble when it is on the decline and may be at a higher risk of bankruptcy than an unlevered firm in the same situation. Finally, analyzing the existing level of debt is an important factor that creditors analyze when a firm wishes to apply for further borrowing.