A leverage ratio is a comparison of a combination of a company's debt, equity, assets and interest payments to ascertain its long-term solvency and ability to meet its financial obligations. Leverage, or gearing, refers to the use of loans or other forms of debt to finance acquisitions or investments. The goal of using these financing options is to earn a higher rate of return than the rate of interest on the loan and amplify gains. Companies with a high degree of leverage are considered risky and highly vulnerable to economic downturns because they must continue to meet obligations to the debt in spite of poor production or sales.
The three most commonly employed leverage ratio formulae are the debt-to-equity ratio, the debt ratio, and interest-coverage ratio. Acceptable leverage ratios are determined by comparison to ratios of other entities in the same industry. They are also determined by tracking of the same ratio for one company over time.
The debt-to-equity ratio is the most commonly used leverage ratio, providing a measure of a company's liabilities in relation to the funds given by shareholders. A greater proportion of shareholder capitalization provides a safety net and is viewed as a sign of financial strength. This ratio is calculated by dividing the total debts by the total equity of the shareholders. The lower the number, the less gearing or leverage that the company is using. Since the leverage ratio is used to assess long-term solvency, many companies deduct the accounts payable, a short-term debt, from the total debt figure before completing the ratio calculation.
Another type of leverage ratio, the debt ratio or debt-to-asset ratio, indicates what portion of the company's assets is financed by debt. The debt ratio is determined by dividing the company's total debts by its total assets. A higher debt ratio signifies a higher degree of leverage used by the company. The operating liabilities are often deducted from the total debts before calculating the ratio.
Alternatively, the interest-coverage ratio indicates the relative ease with which a company can pay the interest associated with its debt. The formula divides the amount earned per share by the interest expenses, before interest and taxes are subtracted from the earnings. In general, an interest-coverage ratio of less than two is a red flag that the company may be unable to fulfill its interest obligations. This ratio is monitored as a critical indicator of a company's viability since even a deeply indebted company may be able to make its interest payments. Once this ratio falls, default or bankruptcy may be imminent.