A leverage ratio shows the capital structure of a business and in particular the level of debt relative to equity. It represents the degree to which a business relies on debt financing to support its operations. A higher leverage ratio indicates that a business has a larger proportion of debt in its capital structure. This can increase the risk of default and financial distress. In contrast a lower ratio indicates lower debt relative to equity and a more conservative capital structure.
Leverage Ratio Analysis
In general, a leverage ratio of 2:1 or lower is considered to be a healthy level for most businesses. However, the appropriate level of leverage can vary depending on the industry, the business’s growth prospects, and other factors. Some industries, such as utilities and telecoms, typically have higher levels of debt due to their large capital expenditures.
A financial leverage ratio should not be viewed in isolation but looked at over a period of time using trend analysis. Additionally the ratio will vary from industry to industry, so it is important to make comparisons to similar businesses in your sector. Furthermore, 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.
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 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
The leverage ratios assess a business’s 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.
Popular Leverage Ratio List
A selection of popular leverage ratios from the Double Entry Bookkeeping Ratios Guide.
- Gearing Ratio Analysis
- Debt Equity Ratio
- Interest Coverage Ratio
- Times Interest Earned Calculator
- Debt to Equity Ratio Calculator
- Operating Leverage Ratio Analysis
- Degree of Operating Leverage Calculator
Overall, leverage is a crucial metric for investors and lenders to evaluate the financial health of a business. While some level of debt can be beneficial for growth and profitability, excessive leverage can put the future of a business at risk.
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.