Leverage Ratios

By using a combination of assets, debt, equity, and interest payments, leverage ratio's are used to understand a company's ability to meet it long term financial obligations.  The three most widely used leverage ratio's are the debt ratio, debt to equity ratio, and interest coverage ratio. 

The debt ratio gives an indication of a companies total liabilities in relation to their total assets.  The higher the ratio, the more leverage the company is using and the more risk it is assuming.  Both total assets and liabilities can be found on the balance sheet.  There is a nuance to be aware of with this formula.  Mentioned above, these leverage ratios are meant to measure long term ability to meet financial obligations.  Well, when we take a look at our Total liabilities number in more detail, items such as accounts payable are included.  This is a short term liability which is essential for the proper functioning of the business and not a liability in the sense that we are discussing it here. 

Debt Ratio

The debt to equity ratio is the most popular leverage ratio and it provides detail around the amount of leverage (liabilities assumed) that a company has in relation to the monies provided by shareholders.  As you can see through the formula below, the lower the number, the less leverage that a company is using.  Again, like the debt ratio, we must understand the drawbacks of this formula.  Total liabilities include operational liabilities that are required to run the business.  These are not long term in nature and can distort the debt to equity ratio.  Some will exclude accounts payable from the liabilities and/or intangible assets from the shareholder equity component. 

Debt To Equity Ratio

The interest coverage ratio tells us how easily a company is able to pay interest expenses associated to the debt they currently have.  The ratio is designed to understand the amount of interest due as a function of a companies earnings before interest and taxes (EBIT).  Some will actually replace EBIT with EBITDA.  It is different for each sector, but an interest coverage ratio below 2 may pose a threat to the ability of a company to fulfill its interest obligations.  The interest coverage ratio is very closely monitored because it is viewed as the last line of defense in a sense.  A company can get by even when it is in a serious financial bind if it can pay its interest obligations.

Interest Coverage Ratio
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