Leverage Ratio

Definition

The term leverage ratio is used to describe several measures of a company's financial leverage.  Also known as gearing, leverage measures the amount of debt a company has issued relative to other capital such as equity.

Calculation

The three most common leverage ratios include the debt ratio, debt-to-equity, and interest coverage.

Debt Ratio = Total Liabilities / Total Assets

Debt to Equity = Total Liabilities / Owner's Equity

Interest Coverage = Operating Income / Interest Expense

Explanation

Leverage is often used interchangeably with the term debt.  Creditors consist of bondholders and other financial institutions that have loaned money to a company.  In exchange for the use of their money, companies pay creditors a rate of interest on the outstanding principal.

If a company cannot make payments to creditors, they have the first claim to the assets of the company.  If a company does not generate enough profits to pay money owed to creditors, they can force the company to sell its assets to help repay this money as part of a bankruptcy proceeding.

Leverage ratios are used by investors, analysts and creditors to measure this risk of non-payment.  When drawing conclusions about the relative performance of a company, benchmark comparisons should be made with competitors in the same industry.

Example

Company A's balance sheet indicates total liabilities of \$16,196,000, stockholders equity of \$15,420,000, and total assets of \$31,616,000.  The two leverage ratios derived from this information include:

Debt Ratio

= \$16,196,000 / \$31,616,000, or 0.51

Debt to Equity

= \$16,196,000 / \$15,420,000, or 1.05