The dictionary meaning of leverage is the use of lever so as to get more power in any action done by an individual; in the case of finance, leverage means the use of debt by the company in its balance sheet so as to get more profits. However, there is the risk of a company using too much debt in the balance sheet which can result in trouble for the company, hence it is important to know an ideal level of leverage which can be assessed through leverage ratios. There are many types of leverage ratios, let’s look at list of leverage ratios –
- Debt to Equity Ratio – This ratio is calculated as Total Debt/Shareholders Equity where total debt includes short-term debt like current liabilities, short-term bank loan, and overdraft as well as long term debts which include items like debentures, bank loan. Shareholders equity is calculated by subtracting total liabilities from total assets of the company. Ideally, a company will like to have a ratio less than 2 because anything above this figure can put a strain on company’s balance sheet as the use of too much debt would mean fixed monthly interest payment which company has to pay no matter whether it’s earning the profit or making a loss.
- Interest Coverage Ratio – This ratio is calculated as EBIT/Interest Expense where EBIT refers to earnings before interest and taxes and interest expense is total interest payable by the company during a financial year. A higher ratio is considered as desirable because higher ratio implies that company has enough funds to pay interest so for example if there are 2 firms while firm A has interest coverage ratio of 5 and firm B has interest coverage ratio of 10 then firm B is more financially sound as far as interest coverage ratio is concerned because earning are 10 times of interest paid by the firm.
- Debt Ratio – This ratio is calculated as Total Liabilities/Total assets where total liabilities includes all things which company owes to outsiders whereas total assets include all items which company owns. Ideal debt ratio depends on the industry in which company is operating, however, a ratio less than .30 is considered well because it means the company has fewer liabilities in comparison to assets and it will not have to sell all its assets to pay liabilities which is the case when the ratio is equal to 1.
- Equity Ratio – This ratio is calculated as Total Equity/ Total assets where total equity includes capital invested by the owner of the company. A higher ratio is indicative of strong commitment by the owners in the company and also gives the company an option to raise debt whenever the company wants as banks and financial companies while giving loans prefer companies which have low leverage or debt in balance sheet.
As one can see from the above that leverage ratio are very important and useful as far as knowing about the debt levels and interest paying capacity of the company is concerned and leverage ratios can throw early signals as far as debt paying capacity of the company is concerned.