Leverage Ratio Definition
Financial leverage ratio indicates level of debt the business is using to finance its business activities. This ratio is a comparison of debt to assets or equity, whichever is selected.
Leverage Ratio Formula
Depending on the comparison selection, there the following leverage ratio can be used:
Debt to Equity ratio – this ratio compares debt and equity. The following leverage ratio formula is used:
This ratio indicates what is the share of debt financing compared to equity financing of the business activities.
Debt to Assets ratio – this ratio compares debt to assets. The following leverage ratio formula is used:
This ratio indicates what part of assets is financed by debt.
Understanding Leverage Ratio
It is quite common to finance business activities with borrowed capital, instead of using own financial means of the shareholders. However, high debt level is related with higher risk of liquidity and inability to pay debts on time.
Leverage ratio should be used together with other financial ratios to determine the financial health of the business. Also it is recommended to compare leverage ratio of the particular business with other business operating in the same industry.
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