Types of Leverage Ratios

The dictionary meaning of leverage is the use of lever so as to get more power in any action done by an individual; in the case of finance, leverage means the use of debt by the company in its balance sheet so as to get more profits. However, there is the risk of a company using too much debt in the balance sheet which can result in trouble for the company, hence it is important to know an ideal level of leverage which can be assessed through leverage ratios. There are many types of leverage ratios, let’s look at list of leverage ratios –

Types of Leverage Ratios

Debt to Equity Ratio

This ratio is calculated as Total Debt/Shareholders Equity where total debt includes short-term debt like current liabilities, short-term bank loan, and overdraft as well as long term debts which include items like debentures, bank loan. Shareholders equity is calculated by subtracting total liabilities from total assets of the company. Ideally, a company will like to have a ratio less than 2 because anything above this figure can put a strain on company’s balance sheet as the use of too much debt would mean fixed monthly interest payment which company has to pay no matter whether it’s earning the profit or making a loss.

Interest Coverage Ratio

This ratio is calculated as EBIT/Interest Expense where EBIT refers to earnings before interest and taxes and interest expense is total interest payable by the company during a financial year. A higher ratio is considered as desirable because higher ratio implies that company has enough funds to pay interest so for example if there are 2 firms while firm A has interest coverage ratio of 5 and firm B has interest coverage ratio of 10 then firm B is more financially sound as far as interest coverage ratio is concerned because earning are 10 times of interest paid by the firm.

Debt Ratio

This ratio is calculated as Total Liabilities/Total assets where total liabilities includes all things which company owes to outsiders whereas total assets include all items which company owns. Ideal debt ratio depends on the industry in which company is operating, however, a ratio less than .30 is considered well because it means the company has fewer liabilities in comparison to assets and it will not have to sell all its assets to pay liabilities which is the case when the ratio is equal to 1.

Equity Ratio

This ratio is calculated as Total Equity/ Total assets where total equity includes capital invested by the owner of the company. A higher ratio is indicative of strong commitment by the owners in the company and also gives the company an option to raise debt whenever the company wants as banks and financial companies while giving loans prefer companies which have low leverage or debt in balance sheet.

As one can see from the above that leverage ratio are very important and useful as far as knowing about the debt levels and interest paying capacity of the company is concerned and leverage ratios can throw early signals as far as debt paying capacity of the company is concerned.

0 comments… add one

Leave a Comment


Related pages


examples of inferior goods and normal goodsillegal immigration disadvantagesunbilled revenue meaningdisadvantage of advertisementsforex reserves by countryadvantages and disadvantages of dictatorshipurbanisation benefitsfmcg companies full formwholesale funding vs retail fundingdefine foreign exchange reservesexample of nondurable goodsamortization expense journal entrybarter system exampleunearned income in balance sheetadvantages and disadvantages of population in indiacash flow statement in hindifull form of tds in bankinga study of non operating expenses of proprietary concerndemerits of decentralisationmaximum market skimmingbarter trading systemsteps on how to withdraw money from atmsubstitutes in economics examplescriticism of absolute advantage theorycompare and contrast socialism and capitalismwhat is privatization and commercializationautocratic coachinggoing concern accounting conceptjournal entry for cash received in advanceskimming pricing strategy definitionexamples of marginal costingadvantages and disadvantages of joint venturesadvantages and disadvantages of population growthunsystematic risk examplessystematic risk and unsystematic risk examplesfullform of tdsprepaid rent balance sheetskim pricing definitiondistinguish between systematic and unsystematic riskdisadvantages of delegation of authoritydisadvantages of advertisementdisadvantages of mergers and acquisitionsdiscounted cash flow advantages and disadvantagesdeferred revenue entrywhat is the difference between monopoly and oligopolydistinguish between revenue and capital expendituresaccounting materialityautocratic advantagesdefinition of drawer drawee and payeeunearned service revenue journal entrybalance sheet vertical analysiscurrent liabilities examples balance sheetunearned revenue earned journal entryfreight inwardssubstitutes and complements economicswhat is unearned revenuewhat is the difference between job costing and process costingadvantages and disadvantages of equity sharesjob and process costingindirect quotation examplethe merits and demerits of internetmeaning of indirect expensesautocratic managersdirect quotation to indirect quotationmeaning of forfeitingexamples of explicit costslr in banking termswhat is pre open trading sessionassumptions of break even analysis accountingexamples of planned economy countriesimportance of hire purchasepros of a command economyhorizontal mergers examplesdisadvantages of break even analysisbenifits of ppf