Leverage Ratios Definition – Meaning, Example and Importance

leverage ratios definition

Leverage Ratios Definition and Example

Leverage Ratios Definition – Ratios related to a company’s use of debt. They include interest coverage and debt to equity and help people assess a company’s ability to pay what it owes.

In simple words, the ratios that measures the level of debt in a company are known as leverage ratios. We all know that company finance its assets with the mixture of both debt and equity.It is very important that management should evaluate what the right proportion of debt or equity in the capital structure of the organisation.

Too much debt or equity, both are not good for the business. Too much equity leads to the dilution of the ownership of the existing owners. On other hand, too much debt leads to default risk or bankruptcy. There are various types of leverage ratio which are helpful in evaluating the level of debts. The most common among them are debt to equity ratio and debt ratio.

Leverage Ratios Example

To understand the leverage ratios definition more clearly, let’s have a look over two most common example of leverage ratios.

Debt-to-Equity Ratio – It refers to the ratio of total debt to total equity of the business. For example – ABC company’s Balance Sheet on 31 March 2017 shows Rs. 5,00,000 of total debt and Rs. 7,00,000 of equity.

So the debt-to- equity ratio = 5,00,000/7,00,000

= 0.71 times or 71%

Debt Ratio = It refers to the ratio of total debt to total assets. For example XYZ company financial statement shows Rs. 3,00,000 of debt and Rs. 8,00,000 of assets.

So debt ratio = 3,00,000/8,00,000

= 0.37 times or 37%

Related Financial Terms of Leverage Ratios

Importance of Leverage Ratios – Why Leverage Ratios is Used?

Leverage ratios shows how leveraged is an organisation. In simple words, it refers to the calculated risk taken by the company. A high debt ratio shows that company has taken lots of borrowings. This indicates that, when time comes, company has to return the principal amount as well as has to pay the interest. This is a burden on company. And if the interest increases it also leads to more burden on the cash flows of the organisation. Similarly if the debt ratio is lower, there is less burden on the company.

On the other hand, a higher debt to equity ratio indicates that company would not be able to meet the obligations when the debt becomes due. Similarly a lower debt-to-equity ratio is also not good as it indicates that organisation is not taking the advantage of leverage.

Investors and Creditors usually go for companies who have low leverage ratios. Because in case any mishappenings, both the parties will still remain in the win – win situation.

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