What is Leverage Ratio?
Leverage Ratio indicates the mix of funds provides by the owners and lenders. As per the general rule, there must be an appropriate mix of debt and owner’s equity in financing the firm’s assets.
The short term creditors like bankers and suppliers of raw materials are more concerned with the firm’s current debt-paying ability. Whereas long term creditors like debenture holders, financial institutions, etc are more concerned with the firm’s long term financial strength. In simple words, a firm needs to have strong both short and long term financial position.
Leverage Ratio is also ascertain in order to judge the long term financial position of the firm, financial leverage as well as the capital structure.
Implications of Leverage Ratio
The manner in which assets are financed has a number of implications.
- Between Debt and Equity, debt is more risky from the firm’s point of view. This is the legal obligation of the firm to pay interest to debt holders. No matter whether has made profits or not. If firm is unable to pay the debt holders, they can take legal action against the firm. In extreme condition, they can also force the liquidation of the company.
- Use of debt is advantageous for the shareholders in two ways –
- they can retain control of the firm with a limited stake.
- their earnings get magnified, when a firm earns a rate of return on the total capital employed higher than the interest rate on the borrowed funds. This process of magnifying the shareholder’s return through the use of debt is called financial leverage or financial gearing or trading on equity.
- A highly debt burdened firm will find difficulty in raising funds from creditors and owners in the future. Creditors treat the owner’s equity as a margin of safety. If the equity base is thin, the creditors risk will be high. Thus leverage ratio is calculated to measure the financial risk and the firm’s ability of using debt to shareholder’s advantage.
Leverage ratio is calculated from the balance sheet items to determine the proportion of debt in total financing. Many variations of this ratio exists. However all the ratio indicates the same thing.