What is a Leverage Ratio?

Leverage Ratio Definition

A leverage ratio is used to show the capital structure of the business and in particular the level of debt in relation to owners equity. A business with a high level of debt is considered to be more risky but will give greater returns to the owners provided cash and profit are managed correctly.

Popular Leverage Ratio List

A selection of popular leverage ratios from the Double Entry Bookkeeping Ratios Guide.

Leverage Ratio Analysis

A leverage ratio shows how the assets of a business are being funded and whether interest payments on the debt can be covered by the profits of the business.There is no correct value for a leverage ratio, it all depends on the type of business and the industry in which it operates in

A financial leverage ratio should not be viewed in isolation but looked at over a period of time using trend analysis and in comparison to other businesses in your industry.

In addition, in order to give a full picture of what is happening, they should be viewed relative to other ratios calculated for the business such as liquidity ratios, profitability ratios, efficiency ratios, activity ratios, and investor ratios.

The leverage ratio will vary from industry to industry, so it is important to make comparisons to similar businesses in your sector. A business with a high level of debt is said to be highly leveraged. A high level of debt is not necessarily a bad thing, if the return on the debt is greater than the interest on it, the owners will benefit.

Leverage Ratio Formula

There are numerous examples of leverage ratios, however, it is important to select the key ratios which relate to your business. The industry sector, size, and complexity of the business will determine the most appropriate ratios to use and many may not be relevant or worth calculating, particularly for a small business.

The following list of leverage ratios are a useful starting point.

Leverage Ratios
Leverage Ratio Leverage Ratio Formulas
Gearing Ratio Debt / (Debt + Equity) x 100%
Debt Equity Ratio Debt / Equity
Interest Cover Profit before Interest and Tax / Interest

Leverage and Solvency Ratios

Leverage ratios assess a businesses ability to pay off long-term debt including obligations to creditors, bondholders, and banks and for this reason are sometimes referred to as solvency ratios.

Last modified March 11th, 2020 by Michael Brown

About the Author

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

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