Leverage ratios compare a company’s debt, equity, assets, and interest payments to assess its long-term solvency. The debt ratio, debt-to-asset ratio, and interest coverage ratio are commonly used formulas. Acceptable ratios are determined by industry standards and tracking a company’s ratio over time. Highly leveraged companies are considered risky and vulnerable to economic downturns.
A leverage ratio is a comparison of a combination of a company’s debt, equity, asset and interest payments to determine its long-term solvency and ability to meet its financial obligations. Leverage, or leverage, refers to the use of loans or other forms of debt to finance acquisitions or investments. The goal of using these financing options is to earn a rate of return that is higher than the interest rate on the loan and to expand your earnings. Highly leveraged companies are considered risky and highly vulnerable to economic downturns because they must continue to meet debt obligations despite low production or sales.
The three most commonly used leverage ratio formulas are the debt-to-leverage ratio, the debt-to-leverage ratio, and the interest coverage ratio. Acceptable leverage ratios are determined by comparison to the ratios of other entities in the same industry. They are also determined by tracking the same ratio for a company over time.
The debt ratio is the most widely used leverage ratio, which provides a measure of a company’s liabilities relative to funds granted by shareholders. A higher shareholder capitalization ratio provides a safety net and is seen as a sign of financial strength. This ratio is calculated by dividing total debts by total shareholders’ equity. The lower the number, the less leverage or leverage the company is using. Since the leverage ratio is used to assess long-term creditworthiness, many companies deduct accounts payable, short-term debt, from the total debt figure before completing the ratio calculation.
Another type of leverage ratio, the debt-to-leverage ratio or debt-to-asset ratio, indicates how much of a company’s assets are financed by debt. The debt ratio is determined by dividing the company’s total debts by its total assets. A higher debt ratio means a higher degree of leverage used by the company. Operating liabilities are often deducted from total debts before calculating the ratio.
Alternatively, the interest coverage ratio indicates the relative ease with which a company can pay the interest associated with its debt. The formula divides the amount earned per share by interest expense, before interest and taxes are subtracted from earnings. In general, an interest coverage ratio of less than two is a red flag that the company may be unable to meet its interest obligations. This ratio is monitored as a critical indicator of a company’s viability, as even a deeply indebted company can make its interest payments. Once this ratio falls, default or bankruptcy may be imminent.
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